CFM , IIPMB

1. Derivatives Disasters:
The Legal Perspective
Dr. M. Panduranga Vithal
Prof. Finance & Strategy
IIPM

2. It has been around 15 years since serious
equity derivatives trading began in the
financial centres of world markets. In this
time, numerous overseas centres have
developed their own derivatives markets
and the global derivatives market has
become a reality. India stands poised on
the edge of a decision to start trading in
financial derivatives.

3. The DisastersThe Disasters
In recent years a lot of publicity has been given to the so
called “derivatives disasters”
Some of the publicized losses are:
Hazell versus London Borough ofHazell versus London Borough of
Hammersmith and Fulham-1991:Hammersmith and Fulham-1991:
Between 1986-1988 this local authority ran up losses
of over US $900 million on derivatives. The case was
one of a number of local authority swap and related
derivatives cases and this particular litigation reached
the House of Lords. The court held that the transactions
were Ultra Vires. This was the first high profile deri-
vatives disaster to hit the markets.

4. Allied Lyons - 1991:Allied Lyons - 1991:
In March 1991, this commercial company ran up
losses of US $265 million in Foreign Exchange (FX)
options.
Metallgesellschaft - 1993:Metallgesellschaft - 1993:
Its oil futures trading strategy ran up losses of up to
US $ 1.3 billion in December of that year.
Orange CountyOrange County - December 1994 :December 1994 :
The municipality of Orange County declared losses
of US $ 1.7 billion on leveraged interest rate
products

5. Gibson Greetings v Bankers Trust -1994:Gibson Greetings v Bankers Trust -1994:
Gibson Greetings was Cincinnati based greetings
cards company which sued Bankers Trust essentially
claiming that they had been misled about the swaps
which they had purchased from Bankers Trust. Many
of the transactions were leveraged which caused
Gibsons’s losses to increase substantially with small
changes to interest rates. The case was settled out of
court for US $23 million..
 Procter & Gamble v Bankers Trust- 1994:Procter & Gamble v Bankers Trust- 1994:
P&G challenged the legal enforceability of two highly
leveraged swap trades and instituted proceedings
against Bankers Trust (BT) in a federal court in Ohio.

6. A key element of the case was the common law fraud
count. P7G claimed rescission or damages. BT claimed
US 200 million. The case was settled in 1996, P&G
agreed to pay US $35 million of the amount claimed
by BT and to assign a further sap worth US $14
million to BT. The settlement left BT bearing 83% of
the losses.
Bankers Trust International PLC vBankers Trust International PLC v
Dharmala Sakti Sejahtera- 1995:Dharmala Sakti Sejahtera- 1995:
This litigation took place in the commercial court in
England and judgement was rendered in December.
The case concerned leveraged interest rate swaps.
Bankers Trust wa successful in this litigation and was
awarded US $65m plus interest.

7. The Barings DisasterThe Barings Disaster :
How did a young trader from some far-flung regional
office bankrupt a 200 hundred year institution
before the management was even aware of it? How
can they protect themselves against risk that they
may not even realize they are taking?
We answer this with another question - what was the
business that Nick Leeson was supposedly doing?
How could a trader in Singapore make huge
amounts of money in liquid markets that had been
worked on by the big US houses since the 1980’s?
He was meant to be arbitraging minute
differences that can occur momentarily between
the prices of Nikkei futures between the Singapore

8. And Osaka exchanges. The arbitrage strategy should
have been to go long on one contract and short of
the other. Leeson appears to have gone long of
both markets and writing call and put options to
generate premium income which he was using to
pay the margin calls on the exchanges.When he
started running out of cash he requested hundreds
of millions more from head office in London, who
paid out despite their lack of understanding as to
its true usage. Part of the reason for turning a blind
eye was that the profits that leeson was reporting
translated directly into their bonuses, thus
compounding the effect of the agency conflict.
Perhaps the final irony is that when the negotiations
were going on to sell the business, senior
management were still focussing on the need to

9. Preserve their bonuses, ostensibly to maintain
morale. What Barings lacked was a powerful
independent risk control function able to monitor
risk independently of powerful traders. They lacked
a rigorously separated back office function and
perhaps most damming of all, a lack of a common
sense understanding of the business which would
have raised questions on how such large profits
could arise from an activity (arbitrage) that could
never generate it.

10. Orange County:Orange County:
Orange County illustrates another case of agency
conflicts in financial institutions. In 1994, Robert
Citron, the Treasurer at orange County, made a
huge bet on interest rates and used a number of
derivatives to implement his personal view. He
could have taken the same bet without using
derivatives by borrowing money and leveraging
his bond portfolio.

11. At a personal level, he was regarded as an honest
man with a track record of taking aggressive
investment stances and coming out right. The
question that arises is whether he should have
made such a large bet at all. There was no
system at the top management of Orange
County who was monitoring the risks that he
was taking and who he was accountable to.

12. Example 2.4 :
On a particular day, the shares of Tata Iron and
Steel are selling at Rs. 150 in the Bombay Stock
Exchange while at the same time the price in the
Lyons Range in Calcutta is Rs. 140. A stock
broker simultaneously buys the share in
Calcutta and sells it in Bombay. By doing so he
realizes a profit of Rs.10without any risk and
with hardly any capital (barring any margin
required to put through the trade.) This is an
arbitrage transaction.

13. Example 2.5:
A Speculator on the gold futures market anticipates a
price increase from the current futures price of
$450. The market lot being 100 oz, he buys one lot
of futures gold. 100 oz of gold at $450 have a value
of $45,000. But the speculator is only required to
pay out a margin or deposit of $4,500. Now assume
that a 10% increase occurs in the price of gold, to
$495.
The value of 100 oz at $495 is $49,500. Subtracting
original contract value, the profit on the transaction
is $4500. As far as the speculator is concerned, he
has achieved a profit of $4,500 on capital of
$4,500. In short, he has achieved a 100% profit
through a 10% price rise!

14. Speculation Vs GamblingSpeculation Vs Gambling :
It is often alleged by poorly informed critics of futures
market (and indeed of other organized exchanges
as well) that the speculation which such markets
engender is little different from gambling and
should therefore be discouraged. Such a view is,
however, not supported by clear-headed analysis of
facts. There are several important differences
between speculation and gambling, as Baer and
Saxon very clearly brought out . Firstly, speculation
is based on existing risks, which are not created by
the speculator. Gambling on the other hand usually
involves the deliberate creation of risks for the
purpose of laying the wager. Thus, speculation is a
transaction involving transference of risk while
gambling is an exercise in the deliberate creation of

15. Risks for the purpose of laying the wager. Thus,
speculation is a transaction involving transference
of risk while gambling is an exercise in the
deliberate creation of risk. (The risks inherent to
producers and consumers in commodity prices
would not disappear if speculation were eliminated
where as a horse race has no ‘risk’ to a person who
does not wish to gamble.) secondly, a speculative
contract is a contract all the same, in which the
speculator is fully and legally bound. In fact when a
person enters into futures contract, there is no way
of determining whether he is a speculator or hedger
purely by examining the contract itself. The
distinction between a speculative futures contract
ans a hedge contract lies purely in the intention of
the party concerned.

16. On the other hand, a gambling contract may not be
enforceable in law, as it does not involve giving ans
taking of valid consideration. Thirdly, speculation is
an integral part of he marketing process, and has
been shown to play a useful role therein. It thus
has economic utility. Gambling serves no such
purpose.
Is Speculation Desirable? :Is Speculation Desirable? :
The short answer to this question is yes. Without
speculation, as has already been pointed, there can
be no effective hedging since the volume of demand
for long and short hedging will not be equal except
by occasional coincidence. It must be noted that the
practice of speculation, by facilitating hedging,
reduces the costs of marketing costs accrues
(eventually) to the consumer.

17. Secondly, speculative activity increases the liquidity
of markets thereby enabling hedgers to transact
large volumes of business on the market quickly,
easily and without unduly affecting the market
price. In a ‘thin’ market, a single large
transaction would have an unduly high impact on
the market price and might, in the process,
defeat the aims of the hedger. Thirdly, futures
markets are expected, in theory, to minimize
inter-temporal price disequilibria by reducing
seasonal fluctuations; this has also been affirmed
by empirical studies.