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Significance And Consequences Of Using Derivatives Finance Essay

This chapter aims to introduce the reader to the study, its objectives and gives a detailed description of what the dissertation has set out to demonstrate. It presents the study’s problem, the questions posed by the researcher and his hypothesis. Also, for ease of the reader a diagrammatic conceptual framework of the study and a flow diagram of how the researcher will address the study is given here. Moreover, to introduce the reader to the chosen cases, a summary of each case study is drawn up. Finally, the researcher comments on previous research on derivatives, the need for such a study, its contribution and its significance. A glossary of terms used in this study can be found in the appendix.

Overview

Chance (1995), a professor of finance at LouisianaStateUniversity in his paper ‘A Chronology of Derivatives’ sees the first derivatives as appearing in around 580 B.C., when Thales the Milesian purchased options on olive presses and made a fortune off of a bumper crop in olives. Moreover, he continues by explaining that in the 1700B.C., Jacob (Bible, Genesis chapter 29), at a cost of seven years of labour purchased an option that granted him the right to marry Laban's daughter Rachel

He indicates the ‘Royal Exchange in London’ as being the first exchange in derivatives on which forward contracts were carried out, talks about the Dutch Tulip Bulb Mania of 1637, characterised by tulip bulbs forward contracts and notes the first "futures" contracts as tracing back to 1650 in Japan’s Yodoya rice market in Osaka. Chance notes that the next major event was the creation of the Chicago Board of Trade in 1848.

Since then growth in the derivative market has mushroomed to a size of $US 370 trillion in the first quarter of 2007, as indicated by a write-up on economy watch (n.d.). This growth was attributed mainly to the increased use by bankers, investors and other companies.

Derivative products have transformed the way firms view financial risk and mitigate it. Simon (n.d) explained in an article titled, ‘Are Derivatives Financial "Weapons of Mass Destruction"?’ that according to a survey carried out by the Bank of International Settlements in 2008, the potential derivatives bubble has grown to an estimated $516 trillion dollars. She continues by noting, that although these financial instruments have been used to hedge risks that were previously left open not everyone had a good feeling about them and as the group of thirty (G30) note users from both inside and outside of the financial industry, remain uncomfortable with derivatives activity. Moreover, although the latest surveys by the Bank for International Settlements (2009) suggests that the use of derivatives among both financial and non-financial institutions is widespread and growing and many of these firms use them responsibly and employ adequate risk management systems, not all firms are immune to derivatives misuse.

Hull (2008) defines derivatives as being any financial instrument whose value depends on (or derives from) the value(s) of other, more basic, underlying variables. Moreover, he states that derivatives have been viewed as inherently bad financial instruments that have led to financial failures of companies and government institutions.

According to Cochran (2007), the path to understanding the concept of derivatives, which most economists view as a positive innovation that emerged over the past 30 years, is a predominant factor in the global financial markets. Since many derivatives involve cross-border trading, the derivatives market has brought increased international financial fragility and the attendant need for greater supranational governance of the instrument (McClintock, 1996).

Becketti (1995) highlights the general belief that firm-specific (which include credit or default risk, legal risk, market and liquidity risk, operating or management risk )and systemic risks,(which entail greater competition between banks and non-bank financial institutions, greater interconnectedness of financial markets, increasing concentration of derivatives trading, reduced disclosure of financial information through off-balance sheet activities such as the case of Enron, and financial and telecommunication innovations that have intensified reactions to market disturbances) are increased by the derivatives market, wherein the use of derivatives is perceived to have threatening effects on both the financial system and the real sector.

Warren Buffett (2003) describes derivatives in the Berkshire Hathaway Inc. 2002 Annual Report as being “financial weapons of mass destruction” and contracts devised by madmen. An article by ‘Traders, Guns and Money’ (2006) quotes the Financial Times (n.d) as noting that "ever since Warren Buffett memorably described derivatives as "financial weapons of mass destruction" there has been a thriller waiting to be written about them."

Cases such as those of Barings Investment Bank (Barings) in Great Britain, Metallgesellschaft AG (MG) in Germany, the Irish Bank Allied Irish Bank (AIB), China Aviation Oil (Singapore) in China, Sadia in Brazil, the Swiss Bank United Bank of Switzerland, Calyon in USA, Enron in USA, State of West Virginia in USA, State Reserves Bureau in China, Procter & Gamble in USA, NatWest in UK, MF Global in USA, Carnegie Investment Bank in Sweden, the Long Term Capital Management (LTCM) Hedge Fund in USA, Amaranth Advisors LLC (Amaranth) in Canada, Sumitomo Corporation in Japan, Orange County in USA, Caisse d’Epargne in France, the Italian Bank Italease, Bank of Montreal in Canada, and the latest case involving the French Bank Societe Generale (SocGen), to mention some of the most popular, have posed the question on whether derivatives are indeed the culprit that brings about massive failure and loss of enormous sums of money by companies and government entities.

To provide some context about the troubles these instruments are perceived to bring to the economy and about the losses derived from their use, below in table 1 are the top 10 trading losses ever, as noted by Babak (2008). It can be noticed that all, except for one, have involved trading in derivatives.

Table 1. 10 Largest Trading Losses (Babak, 2008)

According to Babak in an article published in March 2006,

“Trading derivatives is like juggling running chainsaws which also happen to be on fire. Unless you know what you’re doing, it will get messy. Each and every one of them started out as a small loss. The only reason why they are up on the board is that they were allowed to balloon into grotesque proportions. If we allow our convictions to overrule our discipline, we’re headed towards the same fate.

If anything, such gigantic losses should, dampen conspiracy theories of market manipulation. After all, if someone can’t bully a market with a few billion, then the market is indeed bigger than anyone and everyone.”

Moreover, according to Adams and Runkle (2000), the complexity of derivatives can be a contributory factor to these losses and failures. However, Muehring (1995) suggests that it is not the inherent quality of derivatives that causes major losses and complexity and that it is not a necessary element of mismanagement. He notes that this is often the result of a “can't-lose mentality” which fails to consider the downside of the investment

However, in order to determine whether it is misuse of this financial instrument, and not derivatives per se, that causes firm failure or large losses, the cases of bankruptcy and severe financial loss reportedly due to derivatives need to be investigated further. This so as to pinpoint the root cause of these incidents.

1.2 The Research Problem

Even though these markets are generally characterised by users as illiquid, segmented, politically unstable, with less regulation and historical financial databases, trading of derivatives products on markets and outside markets (OTCs) has become more active (as seen from reports and documents in chapter 3), mainly due to their advantages for markets' participants. This study, triggered off by this and the below quote from Traders, Guns and Money (2006) aims to discuss some of the main obstacles to the inception of successful derivative products in economies and to provide a number of viable solutions.

“Look, it’s quite simple,” I said, breaking down the hierarchy of the trading floor. “There are sales people – they lie to clients. Traders lie to sales and to risk managers. Risk managers? They lie to the people who run the place – correction, think they run the place. The people who run the place lie to shareholders and regulators.” “Oh yes,” I remembered our quantitative colleagues. “I forgot the quants – our fabulous rocket scientists! When last heard from, they were trying to develop a model for lying.” “And clients?” One of the trainees asked tentatively. I thought about it for a few seconds. “Clients. They lie mainly to themselves!” Entering the world of derivatives trading is to enter this world of beautiful lies.”

the researcher aims with this study, to examine and test whether the large losses and failures experienced by firms when using derivatives is the main consequence of the derivative instrument itself and to determine whether other factors may have caused or added to this. Cases, online material such as interviews and their transcripts and literature need to be looked into, together with interviews, and surveys, which need to be carried out to determine the reasons and propose solutions. The researcher intends to shed light on the misconceptions and myths about derivatives and show that the misuse of derivative instruments causes a firm or a government entity to collapse and not the instrument per se. Thus, in a nutshell, this study will investigate whether derivatives, if properly handled by people who manage them, are very useful instruments for companies and governments.

One can however identify that although much has been written on how to value financial derivatives, not that much has been done on the economic reasons, costs, and impact of their use. The importance of this study is due to the fact that as Morse (1997) suggests there is an increase in the use and popularity of derivatives as a tool in corporate investment portfolios. The quote on the web-site of Roy Davis (2009), noted below, emphasises the importance of becoming aware of the costs and the size of the risks the world is facing so as to be ready or at least informed of how to mitigate a phenomenon described as the ‘Derivatives Chernobyl’.

“Unlike Warren Buffet, Sir Julian Hodge, the Welsh banker, issued his apocalyptic warning three years before the first rash of derivatives disasters involving Metallgesellschaft, Orange County, Sears Roebuck, Proctor & Gamble, happened in 1994. More was to come in 1995 in the form of the Daiwa and Barings scandals. None of those on their own, however, threatened to bring the world financial system to its knees. Until recently the crisis that came closest to doing so involved LTCM in September 1998. Nearly 10 years later, in March 2008, the FED took emergency action to avoid what was called derivatives Chernobyl. That action seemed to have worked ... for a while, but the Credit Crunch has raised worries, could a mega-catastrophe lie around the corner ...?”

This study’s objective is to contribute to the growing body of research that supports the benefits derived from using derivatives and that helps in the understanding and determining of a solution for their safe and efficient use. Moreover, it also aims at understanding and highlighting the costs of using derivatives and analysing the validity of the myths that surround them. Moreover, as said above it will aim to strengthen Davidson’s (2000) introduction to her book ‘Auditing Derivative Strategies’ that reads: ‘Derivatives don’t kill companies! Traders and portfolio managers lose large amounts of money because they don’t understand how derivative structures work, and companies do not have the necessary internal controls in place in this highly risky area to ensure assets are protected’. She sarcastically continues by blaming the media for trying to make everyone believe that derivatives rather than people cause all the problems, by slipping into our investment portfolios to create losses without one knowing. She notes however, that derivatives like anything else can be used as a weapon but as she puts it not investing in derivatives is ‘gambling on uncertainty’.

To gain a better understanding of what is happening in the world and the size of the costs of derivative misuse, the researcher has chosen to study the following highly publicised and documented cases of banks: - National Australia Bank, Barings Bank and Allied Irish Bank; hedge funds: - Long Term Capital Management and Amaranth and other firms: - Enron, Metallgesellschaft AG, Sumitomo Bank and Orange County.

A Chinese wise man once said: “A smart man learns from his own mistakes, a wise man learns from the mistakes of others, and a fool never learns.” (cited by Lam, 2002)

He has also chosen to determine the background and environment surrounding the events by reviewing literature and reviewing relating documentaries. Moreover, to corroborate these findings he has chosen to look into any interviews carried out and to carry out interviews with prominent personalities related to the study such as personalities that experienced losses due to derivatives first hand or worked closely with such personalities or have allot of knowledge of the cases involved. He has also carried out a survey and interviews, with controllers such as risk managers, auditors and compliance, traders, executives and audit committee members involved with derivative trading firms, regulators, and academics.

The surveys, which were carried out online using a free web-survey (kwik surveys - http://www.kwiksurveys.com/) sent to the participants as a web-link, were designed to be mainly closed ended and to answer the main questions posed by the researcher in this study. A comment box for each section and two further comment boxes were put in the survey to allow the participant to comment freely so as to gain as much as information as possible from the participant without opening up the study to much and keeping response within the context and scope of the study. A section for demographics was also set to determine trends and to enable determination of any correlation that may exist between answers and these demographics.

Interviews on the other hand were administered using various methods, face-to-face, on telephone, using Skype, MSN, forums, fax and email. These were carried out so as to enhance the findings of the case studies by looking at live data. Although, the questions asked to each were the same and structured as six questions, they were open-ended and the interviewee was allowed to open-up and elaborate as much as he/she wished. The respondents to the survey and interviews were specifically chosen to ensure value-added to the study. (Survey and Interview Questions can be found in Appendix X and Appendix X)

The researcher will be looking at surveys and interviews to capture efficient use to determine gaps between misuse and appropriate use. Surveys and interviews were chosen since although inefficient use and consequent losses are highly advertised, this is not the same when things run smoothly. Therefore, the researcher is hopeful to capture efficient use methodology through the surveys and interviews.

Summary of chosen cases

1.2.1 Barings Bank PlC: The bankruptcy of Barings, in early 1995, illustrates the problems that can occur when derivatives are used for speculation and when the trading activity is not properly controlled. Although the Bank had more than two centuries of experience in the financial world, it still fell to the misuse of derivatives. It all began when Nicholas Leeson, one of its traders in Singapore, bought thousands of exchange-traded futures contracts based on the Nikkei Average and traded on the Tokyo Stock Exchange. Believing that the Nikkei would rise, and hoping that his gain would be maximised, he bought the contracts without hedging, exposing himself to a potentially damaging loss (Baker, 1995). When the Nikkei index fell and the contracts became due, the bank collapsed because it could not cover the losses.

1.2.2 Allied Irish Bank:- In 2002, AllFirst Financial, a subsidiary of Allied Irish Bank – Ireland's second largest bank – lost US$750 million on foreign currency options trading. The Ludwig report attributes the losses to unsuccessful foreign exchange speculations. The company’s trader at the time, John Rusnak, systematically falsified bank records and documents to hide losses from speculative bets. The inadequate risk management procedures allowed Rusnak to cover the losses with both fictitious and genuine options positions without being noticed for over five years. Like Barings, the AIB disaster is a result of an operational exposure. The Ludwig report documents that the risk managers failed to perform overall reasonableness tests of the trader's activities thereby not recognising that the level of daily turnover and the size of gross positions exceeded the given expected and budgeted profit/ loss and VaR limits.

1.2.3 National Australia Bank: - In January 2004, the bank lost hundreds of millions of dollars in unauthorised foreign currency derivatives. This exposure cost the bank A$360 million, wiping out almost A$2 billion from bank’s market capitalization within a few days. Following this event many senior staff members lost their jobs, the board was restructured and Chairman Charles Allen and Chief Executive Frank Cicutto resigned. The traders, Luke Duffy, David Bullen and Vince Ficarra in Melbourne and Gianni Gray in London, later deemed as ‘Rogue traders’, have been dismissed and are being investigated by the Australian Federal Police.

In October 2003, the traders at NAB were trading highly leveraged call options on the Australian and New Zealand dollar in the anticipation that these currencies would fall against the US dollar. However, these currencies went in the opposite direction from that expected and NAB were losing millions of dollars every day.  Instead of closing off the positions, the traders doubled their bets in order to recover initial losses. They also entered fictitious currency transactions in the bank’s books to cover up their losses. These fictitious transactions and trading limit breach were not detected by internal controls and checks and balances and it was only some months later that a fellow alerted management when noticing discrepancies in trading accounts and alerted the management.

1.2.4 Societe Generale: - One of largest in history, by a single futures trader whose scheme of fictitious transactions appeared as stock markets began to stumble, is the case of French bank Societe Generale in January of 2008. The bank took a 4.9 billion euro ($7.18 billion) hit when closing the unauthorised positions of futures trader Jerome Kerviel. The losses that resulted are booked in the fourth quarter. Societe Generale says Kerviel has a position, or a bet, worth about 50bn euros ($73bn; £37bn) on the future direction of European shares. That is more than the bank's value - about 35bn euros - and about the size of France's entire annual budget deficit. To avoid that potentially catastrophic loss, the bank has to unwind Kerviel's trades, (but as stated above it still costs 4.9bn euros). Societe Generale said Kerviel's background in handling the administration of trades enabled him to deceive those monitoring traders' activities. It says Kerviel invented deals that, on paper, balanced out his bets.

The above cases paint a picture of what can happen if derivatives are misused. Derivatives, as stated before, are inherently complex and this highlights the need for boards of directors and senior management to sufficiently understand these complexities and the uses of derivatives in their firms. Moreover, they must be able to monitor the risks associated with them and be cognizant that derivatives require a control structure that is in keeping with their complexities and the systems needed to adequately process the transactions.

1.2.5 Sumitomo Corporation: One of the largest trading companies in Japan and the largest participant in the physical market for copper, with its volume being twice that of the second largest participant, reported a loss of $1.8 billion in copper trading on the London Metal Exchange (LME), On June 13, 1996. This loss was attributed to trading operations in commodity derivatives by Sumitomo's chief copper trader at the time, Yasuo Hamanaka.

Tomiichi Akiyama (Akiyama), the president of Sumitomo at that time was quoted as saying that the transactions were made solely by Yasuo Hamanaka himself and accused him of abusing Sumitomo's name to carry out unauthorised trading.

This loss was the largest unauthorised trading-related loss incurred by any Japanese company during that time and followed the collapse of UK's 233-year-old Barings Bank mentioned above and the and the Japanese bank Daiwa which lost $1.1 billion in America's Treasury bond market in September 1995 due to the unauthorized trading activities of Toshihide Iguchi, a New York based trader.

1.2.6 Orange County: The County stunned the markets in December 1994, announcing the largest loss ever recorded by a local government investment pool - $1.6 billion, which, shortly thereafter, led to the bankruptcy of the county. This loss resulted from unsupervised investment activity of the County Treasurer, Bob Citron. He was entrusted with a $7.5 billion portfolio belonging to county schools, cities, special districts and the county itself. Citron was able to increase returns on the pool, by investing in derivatives securities and leveraging the portfolio to the hilt. This investment strategy worked fine until 1994, when the Fed started a series of interest rate hikes which, consequently caused losses to the pool. This unrealised ``paper'' loss soon caused the county to declare bankruptcy and liquidate the portfolio, realising the loss.

1.2.7 Metallgesellschaft AG (MG): - Metallgesellschaft AG is a German conglomerate and a traditional metal company with several subsidiaries in its Energy Group. In December of 1993, MG publicly announced that the Energy Group is responsible for losses of about $1.5 billion. MG Refining and Marketing Inc. (MGRM) committed to sell, at prices fixed in 1992, certain amounts of petroleum every month for up to 10 years. MGRM provided a method that enabled the customer to eliminate or shift some of their oil price risk. MGRM thought that their financial resources enabled them to manage risk transference in the most efficient manner.

However, the assumption of economies of scale is mistaken. MGRM attributed to such a great percentage of the total open interest on the New York Mercantile Exchange (NYMEX) that it made liquidation of their position problematic. Moreover, MGRM encountered problems involving the timing of cash flows required to maintain the hedge. There was a lack of necessary funds required to maintain their position. It seems that, despite the fact that this risk management strategy played a major role in acquiring business pursuant to their corporate objectives, management did not have an understanding of the strategy.

1.2.8 Enron Corporation: -Formed in 1985 by a merger between Houston Natural Gas and InterNorth of Omaha, Neb., Enron started off as a natural gas pipeline company. When gas and electricity deregulation hit in the late '80s, the company moved into the business of buying and selling those commodities over the phone or by fax. Traders took orders from buyers, such as independent power companies, and then tracked down potential energy supplies. Within a year of deregulation, Enron's gas services group had captured 29% of the electric power market. As the traders looked for new and better ways to aggregate and analyse market information, they realised that an online marketplace may be the answer.

Enron became the seventh largest company in the US and the world's biggest energy trader. It made extensive use of energy and credit derivatives but became the largest company to go bankrupt in American history after systematically attempting to conceal huge losses. In the wake of the Enron collapse, The Washington Post describes derivatives as "risky, complex and largely unregulated financial contracts." In addition, The Baltimore Sun cited Michael Greenberger, formerly an official at the Commodity Futures Trading Commission, in stating that: "Derivatives, when used hypothetically amount to nothing more than gambling." Even the author of the “Bowie Bonds” novel Linda Davies argues that "derivatives are financial instruments that have no intrinsic value" Callahan and Kaza, (2004)

Derivatives did play a significant role in what was the second largest bankruptcy in American history (behind only WorldCom), but not in the way most people believe. Apparently, Enron a Houston Energy Company did not go bankrupt because it lost money in the derivatives trading. Enron reached the peak of success and profitability in its trading operations and is standing up billions of dollars in profits. According to Partnoy (2002), an economic historian, Enron went bankrupt because it tried to use the profits to disguise heavy losses in its technology and consulting businesses. Partnoy explained that as the accounting troubles surfaced, the company's credibility and standing evaporated together with its sources of cash and credit. Enron is killed by a lack of cash flow and not a lack of profits (Prentice, 2002).

1.2.9 Long Term Capital Management (LTCM):- Initially enormously successful with annualised returns of over 40% in its first years, LTCM lost $4.6 billion in less than four months during 1998 and goes out of business in early 2000. It became the most prominent example of the risk potential in the hedge fund industry. This hedge fund was founded in 1994 by John Meriwether (the former vice-chairman and head of bond trading at Salomon Brothers). Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics, are on its board of directors.

1.2.10 Amaranth Advisors LLC: -The star natural gas trader, a multi-strategy hedge fund founded by Nick Maounis in 2000 (one of the largest US hedge funds), lost about US$6 billion in a week, making it the largest financial loss made by a single trader. Burton and Leising (2006) stated that in June 2006, the company energy trades accounted for about half of the fund’s capital and generated about 75% of their profits.

Rick Brooks, a financial planner in Solana Beach, California, noted that the term “hedge fund” is very generic and compared it to saying that one is a doctor. Just as physicians run the gamut from brain surgeons to podiatrists, hedge funds vary generally in terms of investment strategy and risk level. However, hedge funds do share some extensive similarities. For beginners, like a mutual fund, a hedge fund puts investors’ money to work in the market. However, a significant difference is that these hedge funds are private and usually fell beyond the reach of government regulation. Although they did not have to register with the regulator in this case the Securities and Exchange Commission (SEC), the hedge fund managers have certain fiduciary responsibilities to their investors. Also, because hedge funds under this legislation are not allowed to advertise and promote, their operations, they are generally recognised as secretive or enigmatic. Information on the particular hedge funds is not available, to some extent, because managers do not want to unintentionally do something that might trigger regulator’s (SEC in this case) inquiry.

Research Questions

The proposed research seeks to answer the following questions posed by the researcher as a guideline for the study:

What are the significance and consequences of using derivatives?

Here the researcher wishes to understand and highlight all the risks that derivatives instrument users expect to face. He wants to understand through the study, what were the problems, whether they are a consequence of derivative use (specifically),whether there are common risks and lessons learnt. Also, he would like to understand whether there is a possibility of avoiding the risks and ensuring the safe use of derivatives.

Why are firms losing/failing when using derivative instruments?

This follows from the first question. The researcher wishes to determine whether the risks are all being measured and mitigated or at least measured/known and a decision whether or not to mitigate has been taken. He is interested to understand whether there is a trend or commonality in the cases studied.

Is the problem really the derivative instrument itself? Are derivatives madness, are they bad and dangerous to know?

Here the researcher wishes to determine whether the derivative instrument itself may be a/the reason for misuse. Is it the instrument itself that instigates users to use it badly? Is it its complexity? is it an easy target/tool for misuse?

How are derivatives used and misused?

The researcher is interested here in understanding the various ways in which derivatives have been misused so as to determine the methodology and reasons for using and misusing derivatives. There is the saying that ‘it takes a criminal to catch a criminal’. Therefore, to understand what are the gaps, if any, the researcher needs to determine through examples/cases of misuse what role derivatives played in this and what can/could have been done to ensure safe use of derivatives. Surveys and interviews as explained above will enable the capture of efficient use and to determine gaps between misuse and appropriate use.

Where there other unidentified risks involved when using/misusing derivatives?

Here, the researcher is interested in determining whether derivatives instrument pose more risks than other instruments. He will be examining the risks as in the first questions and seeing whether they are different from the risks posed when using other instruments.

What solutions can be applied to ensure safer use of derivatives? Is regulation or control the answer? Prohibition? or something else?

Once the risks and reasons for misuse have been determined the researcher intends to identify and recommend solution/controls.

1.7 Hypothesis

Consistent with the findings from studies supporting derivatives use and misuse this dissertation hypothesises that a manifold of reasons which include the ‘users’ and controllers’ lack of knowledge, expertise and uneasiness on/with derivatives, of both the users and controllers, rather than the derivatives per se, has led them to make unprofitable decisions which led to the collapse or large losses of companies. To blame derivatives, as Bartram (2009) suggests, is like blaming a car for causing a crash, rather than the drunken driver behind the wheel.

After consulting literature on derivatives, their use and losses blamed on this instrument and following the researchers various years of experience working and training in the field, the researcher feels that communication between the control units (risk managers, compliance and internal audit) and management is one of the main issues that pose a problem to ensure the safe use of derivatives. Moreover, he noticed that the structure and communication methodology used by these units does not help. The researcher paid particular attention not to impose his opinion and experience on the study carried out so as to ensure that there is no bias and skewing towards his preconceived hypothesis. Instead, he used this experience to understand whether his hypothesis is shared and has been tested successfully by other professionals (users and controllers of derivatives).

He feels that the internal control units should be integrated into one unit as depicted below and consistent with the statement by Kang (2007) -‘The first line of defence is always at home. Knowing the ingredients and recipe of what’s being cooked (or more importantly, what you’re eating) is in your best interest.’ The culture of the firm should be changed to one where management is the first line of internal control/defence of a firm (as already noted in the quote by Kang (2007) above). They are the ones who have the most knowledge of what is going on and it is very difficult for the internal control units to be on the ball of every area all the time. Since this would only be possible where the number of controllers are as large as the operations and front officers.

In this way all communications filters and is coordinated through one chief Governance, Risk & Compliance (GRC).The chief GRC should be the person to ensure that work is carried out in line with the following flow chart: -

Where, this is not possible it is hypothesised that the internal control units should communicate effectively. Therefore it is hypothesised that an appropriate and pro-active control framework together with knowledge on derivatives could have helped in avoiding such losses and failures.

Building on literature review on derivatives and in-depth case studies of firms that have been chosen (which as already stated above were highly publicised and one could find volumes of published work) and enhanced by interviews (carried out by the researcher and by others such as book/article authors) with persons associated with the cases/derivative use and corroborated to the findings of the survey administered to users and controllers of derivatives, the researcher will hope to conclude whether the above hypothesis are correct or not.

1.8 Conceptual Framework

Figure 1. Conceptual Framework of the Study

The figure above depicts the conceptual framework of the research. It shows that to address the statement of the problem and to answer the questions mentioned above, the researcher will address each of the following six points depicted in a flow diagram below, in the following chapters by reviewing literature, analysing case studies and carrying out surveys and interviews :

The researcher will be doing this by looking into the following aspects within the literature review, case studies, the survey and interview chapters:-

Provide background for the study, by looking at the growth in derivatives, regulatory development, control structures, characteristics of derivatives, their inherent risks, environment, previous studies and education.

Identify the purpose/s for using derivatives and outlining the benefits. In doing this determining the gap between the original reason/s for use and the real or acquired reason/s.

Highlighting the Regulations, Controls and Politics involved within the derivative use environment. In doing this the researcher will be looking into their development and changes especially following incidents of derivative use failure. He will be discussing control structures/frameworks and the effect of politics (both external and internal) on derivatives use and noting the gaps that existed and still exist between the spirit for having certain regulation and controls and the actual outcome/impact.

Understand the knowledge and expertise on use of derivatives by looking at educational needs and the gaps that still need to be filled in. The researcher is also conscious of the fact that the gap may not be one of education/qualification but employment/recruitment of personnel with incorrect criteria. He will be investigating the reasons for this and whether this is purposely done or not. Moreover, he will be testing the gap between the what the users are suppose to know about derivatives and what they actually know and the impact of this.

Outline the awareness of the risks and controls when using derivatives. The researcher here will be testing the gap between what the users should be aware of and what they are actually aware of. He will also be looking at the impact such a gap may have/had.

Determine the relevance of character, gender, age and environment of derivatives users. When looking at case studies and reading about failures in the use of derivatives one may notice the similarities in character, the young age of the so called ‘rogue traders’, who are generally men and that the environment although somehow modernised, is very similar. The researcher is curious about the effect/impact that these characteristics might have or have had on derivative misuse and whether/how they have contributed.

Determine the ease of use/difficulties encountered in using derivatives. The researcher will be trying to understand the level of difficulty faced by users when using derivatives and whether this has had an impact on misuse.

Analyse the consequences of misusing derivatives and highlight the lessons learnt. The researcher will be looking at cases and determining whether lessons have been learnt and the gaps have been closed or whether the gaps are still open and what needs to be done to ensure the safe use of derivatives.

The intention of the above study work flow is to derive the disparity between the projected and actual impact of use of derivatives, to understand what went wrong, determine the underlying reason/s for the derivative misuse and to find and recommend ways of mitigating them.

1.09 Significance of the Study

Various studies and research has been carried out on derivatives over the years which involved surveys, interviews, statistics, case studies and mathematical theories. In one way or another all have contributed to the vast literature on the subject. Moreover, many authors and journalists have followed and focused their attention on losses blamed on derivatives, making transcriptions of interviews carried out with the so called ‘rogue traders’ to writing biographies of the events, others have focused on understanding derivatives and their contribution and others on controls needed to ensure their safe use – writing text books for universities, preparing course texts and contributing to legislation, standards for best use and regulatory guidelines. Moreover, there are forums and online sources which help in the development of derivative use by crating discussion groups.

This dissertation provides insights on uses and misuses of derivatives and the causes of firm failures/losses. It contributes to the increasing body of literature on firm failures attributed to derivatives and investigates why this has happen and whether it happened only because the derivative too was placed in the hands of inexperienced investors with inadequate control or training. Moreover, this study breaks the myth surrounding derivatives and firm failures by stating that derivatives are an essential corporate tool when properly used to hedge against risk. Since the derivatives myths still condition the minds of management and corporate directors, a further study needs to be conducted to educate them on how derivatives could protect their corporation. This study is focused on setting clear risk management policies and identifies if and how derivatives can be used to ensure that they will be beneficial to managers, directors and controllers.

1.10 A Review of Previous Surveys and Studies

In the last two decades a number of studies have examined derivatives use and misuse form various angles and addressing both financial and non-financial firms. There are studies such as Miаn(1996),that use market and financial statement data to аnаlysе the use of derivatives in non-financial firms. He presents empirical evidence of the determinants that influence the corporate hedging policy, using а sample of 3.022 firms. He classifies firms into 771 hedgers and 2,251 nоn-hеdgеrs using 1992 аnnuаl finаnciаl stаtеmеnts (а 25.5% utilization rate). Nаncе, Smith, & Smithsоn (1993) on the other hand invеstigаtеd thе hеdging аctivitiеs оf 169 firms chosen from Fоrtunе 500 аnd S&P 400, аnd fоund thаt 104 cоrpоrаtiоns usеd hеdging instrumеnts in thаt fiscаl yеаr. Thеir rеsults indicаtе thаt firm hеdging dеcisiоns аrе rеlаtеd tо thе invеstmеnt tаx crеdit, but thеy аrе unrеlаtеd tо finаnciаl distress аnd agency costs. Furthermore, Jacky, Minton аnd Strand (1997) investigated 372 of the Fortune 500 nun-finаnciаl firms thаt had potential еxpоsurе tо foreign currency risk. Based an 1991 finаnciаl stаtеmеnts, thе authors fоund а 41.4% usage rat оf derivatives.

Other studies еmplоyеd survey dot. Far instinct, Black & Gallagher (1986) determined thаt thе handling оf derivatives by nun-finаnciаl firms was mad through forwards, futures, options аnd swaps. Thеir main conclusion was thаt larger оrgаnizаtiоns usеd interest derivatives mar еxtеnsivеly then smaller firms. Moreover, among other studies, thru аrе thе surveys conducted by thе Trеаsury Mаnаgеmеnt Аssоciаtiоn (1996) and the tar studies based an lаrgе-scаlе surveys conducted by specialists оf Wharton Schооl: no in 1994, published by Bednorz, Hoyt, Marston, & Smithsоn in 1995; thе second no conducted in 1995 аnd published by Bednorz, Hoyt, & Marston in 1996; аnd thе last no in 1998, gin published by Bednorz, Hoyt & Marston in that same year. Based on this survey (Wharton Schооl surveys) other studies have been made but thе handling оf derivatives by nun-US companies.

Barmen & Bradbury (1996) carried but а similar study with а simply оf 116 firms listed an thе New Zеаlаnd Stick Еxchаngе. Thеy fоund thаt thе us оf derivatives risks with lеvеrаgе, company size, tаx lasses, аnd thе proportion оf shorts held by mangers. However, it dеcrеаsеs with thе incrеаsе оf interest cоvеrаgе аnd liquidity. Later, Provost, Rоsе, & Millеr (2000) еxtеndеd thоsе investigations tо New Zеаlаnd firms, finding that the incrеаsе in thе us оf derivatives was fоllоwing thе sаmе pаttеrn as thе lаrgеst Аmеricаn аnd Еurоpеаn companies.

Thе Wharton Schооl survey was аlsо еmplоyеd in studies but derivatives’ us in Jаpаn (Yаnаgidа & Inui, 1995), Cаnаdа (Dоwniе, McMillаn, & Nоsаl, 1996), Swеdеn (Аlkеbаck & Hаgеlin, 1999), аnd Аustrаliа (Nguyеn & Fаff, 2002). It was found that thе main rеаsоn fоr using derivatives is fоr minimizing vоlаtility in cаsh flоw аs wеll аs risk cоvеrаgе duе tо thе dеcrеаsе оf lоss prоbаbility. Barmen аnd еt аl. (1997), Jоsеph аnd Hеwins (1997), аnd Bednorz аnd Gеbhаrdt (1998) hаvе obtained similar rеsults in New Zеаlаnd, Еnglаnd аnd Gеrmаny, rеspеctivеly. Thru аrе also a fеw studies an thе sаmе subjеct in еmеrging cоuntriеs, such аs thе cаsе оf Lаtin Аmеricа. Rivаs-Chаvеz (2003) which shоw thе rеmаrkаblе us оf derivatives by finаnciаl firms in Brаzil, Chilе аnd Mеxicо. Оnе оf thе mоst important conclusions is that Latin Аmеricаn bаnks dо nоt оffеr derivatives in оrdеr tо minimize interest rat аnd crеdit risk and thе derivatives usage is not related tо the efficiency оf such bаnks.

1.11 Summary

The objective of this study is to examine and test whether the large losses and failures experienced by firms when using derivatives is a consequence of the derivative instrument itself and to determine whether other factors may have caused or added to this. The researcher hypothesis that derivatives only cause firms severe losses when users and controllers are not knowledgeable about the nature of derivatives, when senior management and those involved in derivatives transactions fail to actively participate in instituting corporate derivatives policies, when the firm fails to meet the goals established in the derivatives policy, and when it fails to establish and maintain a key set of internal controls. He also contends that the lack of communication flow between internal controls and management contributes to this misuse, while changes in the structural/organisational framework of the internal control units can make this flow better and help to protect firms from incurring these losses.

The researcher gives a brief outline of the cases he intends to make an in-dept analysis of and contends that this study contributes to the increasing body of literature on firm failures attributed to derivatives.

http://highered.mcgraw-hill.com/sites/dl/free/0072873957/121268/Hill3e_369_374.pdf

Case Risky Business: Nick Leeson, Global Derivatives Trading, and The Fall of Barings Bank

Satyajit D. (2006), Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives

ftp://ftp.pearsoned-ema.com/HPE_Samples/PressReleases/0273704745-PR.pdf (viewed, 2008)

http://www.icmrindia.org/casestudies/catalogue/Finance/Sumitomo Corporation of Japan - The Commodity Derivatives Fias

Kavaljit S (n.d)How to Lose Millions in Speculative Currency Trading 

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CMM.com (2004) World Business.. Rogue trading saga hits NAB hard

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Davies R (2009) Gambling on Derivatives, Hedging Risk or Courting Disaster? http://projects.exeter.ac.uk/RDavies/arian/scandals/derivatives.html (viewed 2008)

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http://www.reason.com/contrib/show/203.html

ICMR (n.d.) Sumitomo Corporation of Japan - The Commodity Derivatives Fiasco

http://www.icmrindia.org/casestudies/catalogue/Finance/Sumitomo Corporation of Japan - The Commodity Derivatives Fiasco.htm - bot6

Jorion's P. (2009) Orange County Case: Using Value at Risk

to Control Financial Risk (2009) http://merage.uci.edu/~jorion/OC/case.html

Bill Bartram (2009) London Evening standard: standard.com.uk

http://www.thisislondon.co.uk/standard-business/article-23763210-after-...1

Kang R. (2007) Are derivatives for risk management or is risk management for derivatives

http://seekingalpha.com/article/35804-are-derivatives-for-risk-management-or-is-risk-management-for-derivatives

Simon H (n.d.).Are Derivatives Financial "Weapons Of Mass Destruction"?

http://investopedia.com/printable.asp?a=/articles/optioninvestor/08/derivative-risks.asp

Group of Thirty (G30) (1993) Derivatives: Practices and Principles

http://riskinstitute.ch/136160.htm

BIS (n.d.) http://www.bis.org/forum/research.htm

Davidson B.(2000), ‘Auditing Derivative Strategies’

Chance, Don M. "A Chronology of Derivatives." Derivatives Quarterly 2 (Winter, 1995), 53-60.

Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds. New York;

Harmony Books (1841, current version 1980).

This column is excerpted from “Essays in Derivatives” by Don Chance (John Wiley & Sons, 1998) under an agreement with the publisher by Financial Engineering News.

EconomyWatch (n.d) -Derivatives Market Growth

http://www.economywatch.com/market/derivative-market/growth.html

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