on derivative risks in mutual funds
As we continue to break down, in detail, what drives mutual fund investing and the risk investors may encounter, the next topic is by no means an easy one and is not something that would be considered new. Recent turn of the calendar articles have speculated as to why we behave in such a way that we, as investors, tend to have incredibly short memories, even after the sting that 2008 was, and are, for the most part, likely to participate in the next bubble - often with complete abandon and disregard for the risk that might be there.
This belief is well founded when it comes to derivative risk. Here is list of some of the events the financial world has experienced, largely at the hands of derivative traders.
12th Century
In European trade fairs sellers sign contracts promising future delivery
of the items they sold. In essence, this seems like a good idea. The money goes to finance the trade before the trade happens and allows the trading mission for goods in far off lands to happen. In the 12th century though, the risk that what you had invested would actually make it back to the marketplace was high. The New Cambridge Medieval History offers some insight into the financial transaction. Some investors demanded repayment only if the ship returned safely. 13th Century
There are many examples contracts entered into by English Cistercian
Monestaries who frequently sold their wool up to 20 years in advance to
foreign merchants. During this century, derivatives, although that term was not coined for some time, and the risk the investor undertook was now accompanied by information about past trades, current trading conditions and the worth of not only the currencies being exchanged but the creditworthiness of the traders. Think silk road. Early 17th Century
1634-1637 Tulip Mania in Holland
Fortunes are lost in after a speculative boom in tulip futures burst. Every financial writer mentions this at one time or another. I have - many times and never do i seem to understand why such foolish can happen. But this is where it began. Credit along with envy and greed pushed this exotic market and the world for that matter, to near collaspe.
Late 17th Century
Dojima Rice Futures
In Japan at Dojima, near Osaka a futures market in rice is developed to
protect sellers from bad weather or warfare. To understand this, you have to consider rice as the coin of that ancient realm. Rice was paid to feudal lords and they, in turn needed to sell it. There was only so much rice a ruler could eat. Problem was, and it took almost a half-century after the Dojima was first licensed, to understand that the rich were controlling the prices, acting as a central bank for those that were paid in rice. It was until 1773 that the government realized, according to the SamuariWiki, that "the need for governmental control of such policies; exchange rates,
monetary standards and the like had to be set by the government, and
not left in the hands of an increasingly wealthy and powerful merchant
class which was intended to be at the bottom of the neo-Confucian mibunsei class system."
19th Century
1868 Chicago Board of Trade
On April 3, 1848, the Chicago Board of Trade (CBOT) was officially
founded by 83 merchants at 101 South Water Street. Thomas Dyer is
elected the first president of the CBOT. The first trades were offered on "arrive" contracts.
20th Century
Late 1960s - Black and Scholes begin collaboration
Fischer Black and Myron Scholes tackle the problem of determining how much
an option is worth. Robert Merton joins them in 1970. The problem is, it doesn't really work outside of a campus setting. For it to work with any success, remembering of course that an option is priced according to what it might be worth under certain market conditions when it arrives to that market, there must be no-restriction short selling, free borrowing, continuous trading, along with a whole host of other, often non-existent factors in the open market.
April 1973 The Chicago Board Options Exchange
opens.
The CBOE offers investors an opportunity at buying equities but as an option to buy. Consider this: equity options offer the investor
protection of stock holdings from a decline in market price, increased income against current stock holding, help the investor prepare to buy a stock at a lower price, and last but not least, benefit from a stock price rise, without having to buy the stock outright. The CBOE explains that "If you anticipate a certain directional movement in the
price of a stock, the right to buy or sell that stock at a
predetermined price, for a specific duration of time can offer an
attractive investment opportunity."
May/June 1973 The Black-Scholes Model is Published.
It appears in the Journal of Political Economy, one of the journals
that had previously rejected it. it still didn't work in the real world but its publication gave many economist pause - which is what dismal scientists do when they are thinking about abstract stuff with no real world grounding.
At about this time, it all begins to unravel.
1994 Metallgesellshaft loses $1.5 billion on
oil futures.
1995 Barings Bank goes bust.
1998 Long Term Credit Management Bailout
The hedge fund is rescued at a cost of $3.5 billion because of worries
that its collapse would have severe repercussions for the world financial
system.
1999 The Flaming Ferraris
Some traders at CSFB are sacked following allegations of illegal trades in an attempt to manipulate the Swedish stock market index.
21st Century
2001 Enron goes Bankrupt
The 7th largest company in the US and the world's largest energy trader
made extensive use of energy and credit derivatives but becomes the biggest
firm to go bankrupt in American history after systematically attempting to
conceal huge losses.
2002 AIB loses $750 million
John Rusnak uses fictitious options contracts to cover loses on spot and
forward foreign exchange contracts.
2003 Terrorism Futures Plan Dropped
The US Defense Department had thought that such a market would improve the prediction and prevention of terrorist outrages.
January 2004 NAB admits losing a $180 million
Four foreign currency dealers at the National Australia Bank are said to have run up the losses in three months of unauthorised trades.
August 2004 Citigroup bear raid
Citigroup traders led by Spiros Skordos made (euros)15 million by suddenly selling (euro)11 billion worth of European bonds and bond derivatives, and
buying many of them back at a lower price.
November 2004 China Aviation loses $550m in speculative trade
This loss is the largest amount a company in Singapore has lost by betting on derivatives since the case of Nick Leeson and Barings.
October 2005 Refco suspends trading
One of the world's largest derivatives brokers is forced to freeze
trades.
September 2006 Amaranth Advisors loses $6 billion
the US-based hedge fund suffered enormous loses trading in natural gas
futures.
January 2008 Societe Generale loses √õ4.9 billion in unauthorised futures trading
A rogue trader is blamed for the world's largest banking fraud up to that date.
In short, derivatives "are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds. There are two main types: futures, or contracts for future delivery at a specified price, and options that give one party the opportunity to buy from or sell to the other side at a prearranged price."
In a mutual fund, this kind of activity can greatly increase your risk.
Next up: foreign investment risk
Previously: Active Trading Risks Counter Party Risk
Derivative Risks
bluecollardollar: from the blogRetirement Planning: The Soothing Powers of Prediction
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