Where it all went wrong case studies Donald Douglas and Chris Howell, Cambridge Risk Ltd

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Where it all went wrong case studiesDonald
Douglas and Chris Howell, Cambridge Risk Ltd

• February 2008

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Important Information

• The information and opinions contained in this
  document are not intended to be a comprehensive
  study, should not be regarded by any recipient as
  providing the basis for any investment decision
  and should not be treated as a substitute for
  specific advice concerning individual situations.
• The case studies described in this presentation
  are based on publicly available information and
  the conclusions drawn are based on Cambridge
  Risks experience of hedging. They are intended
  to be short descriptions of the main problems
  that arise from hedging.
• Cambridge Risk Limited neither gives any warranty
  nor makes any representation as to the accuracy
  or completeness of this document and does not
  accept any liability for the consequences of any
  reliance upon any statement of any kind
  (including statements of fact and of opinion)
  contained herein.
• Cambridge Risk Limited is authorised and
  regulated by the Financial Services Authority

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Case studies
Ashanti Pasminco Barings Procter Gamble /
Bankers Trust Natwest Markets
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1. Ashanti

• Background
• One of the largest gold mining companies in the
  World in the 90s
• It sold forward large parts of its production -
  including using complex derivatives
• It entered into margin agreements with most of
  its bankers
• When the price rose abruptly (because of the
  Washington Accord), the banks called margin of
  cUS600m which Ashanti could not fund
• It agreed (after a long negotiation) to
  compensate banks for the loss of the right to
  margin by giving warrants over its shares
• Results
• Near collapse and major restructuring
• Shareholder dilution
• Possibly the loss of half of a key asset (the
  Geita gold mine)
• Lessons
• Beware of margining agreements
• Beware of exotics
• Beware of overhedging

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2. Pasminco

• Background
• Major Australian producer of zinc, lead and
  silver
• Entered into an extensive programme to hedge its
  US dollar receipts into Aus based on estimated
  prices of zinc
• The zinc price fell well below the estimates
  making the fx position naked
• The Australian dollar weakened against the US
  dollar so losses incurred on naked position
• Losses eventually totalled c A1.4bn
• Results
• company entered into administration
• nb there were other reasons
• Lessons
• Make sure the hedge matches the item being hedged
• If your hedge runs into trouble, adjust it as
  soon as possible

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3. Barings

• Background
• Leading and highly respected UK merchant bank
• Singapore trader (Nick Leeson) took unauthorised
  positions in Singapore and Japan
• Portraying them as arbitrage (long vs short
  trades) when margin demands came from the
  clearing houses
• And controlled the back office and distorted
  reporting
• As the markets moved against him , he doubled up
  in the hope of covering losses
• And sold japanese bond futures calls to gain cash
• Results
• The Bank of England was unwilling to rescue
  Barings- losses were unquantifiable
• Barings was bankrupt
• Pain for the banking system in the UK
• Lessons
• Management must understand its trading activities
  and why it makes money
• The back office must be independent

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4. Procter and Gamble / Bankers Trust

• Background
• Bankers Trust (BT) was one of the leading banks
  in the derivatives market in the 90s
• It sold contracts to Procter Gamble which would
  only be profitable in a stable market but could
  result in a twenty to one increase in the size of
  positions if interest rates increased
• Well they did
• PG sued BT for US195 million citing lack of
  disclosure of risk
• BT claimed that PG had a reputation for using
  complex derivatives and had retained experts on
  the interest rate outlook
• BT was also sued by 3 other clients over similar
  instruments
• Results
• BT settled out of court (with PG and other
  clients)
• BT was fined by the federal securities regulator
  (in respect of an other client)
• Possibly led to the eventual sale of BT to
  Deutsche Bank
• Lessons
• Beware of exotic derivatives esp with gearing
• Stick to hedges that hedge

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5. National Westminster Bank

• Background
• Natwest ran a significant interest rate options
  book
• In 1997, it announced losses of 50m in the book,
  later to rise to 90m
• The bank had not valued out of the money options
  correctly to allow for different volatility
  rates
• Results
• The equity market cut Natwests market cap by
  several times the reported losses
• Fines and censure by the regulator
• Possibly one of the reasons why Natwest
  eventually lost its independence
• Lessons
• Need for strong internal control over hedging
  activities / strong middle office
• Need for management understanding of trading
  activities
• Need for proper valuation procedures

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Contact Cambridge Risk

• E-mail donald.douglas_at_cambridgerisk.co.uk
• Telephone [phone] and 44 7889 657590
• Address 15 Long Road, Cambridge CB2 8PP
• Chris Howell 44 7779 326808

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Where it all went wrong case studiesDonald
Douglas and Chris Howell, Cambridge Risk Ltd

• February 2008