From Nobel Prize to “Financial Weapons of Mass Destruction”: Perspectives on the Largest Cases of Derivatives Losses by Non-Financial End-Users (1987-2017)

Abstract

Derivatives have consistently been held responsible for major corporate and institutional financial losses. They are unique in the sense that, unlike other financial products, some critics have directly urged for their demise. Companies make bad investments, fund managers lose money in the bond and stock markets, retail investors are victims of stock market scams and Ponzi schemes, and banks fail because of bad loans. However, these products (loans, bonds, equities) have rarely, if ever, been the object of such public outcry and virulent criticism as derivatives. Criticism of derivatives is generally based on the idea that they are arcane products that banks sell to unsuspecting corporate and government treasurers who do not understand them and, especially since 2008, include asymmetric payoffs that penalize their users. Undoubtedly, most, if not all, of the negative press arises from high profile cases of companies that have lost significant amounts of money with these products, the so-called “derivatives debacles.” This paper aims to answer the question of whether this criticism is justified from a historical perspective by analyzing the thirty largest losses caused by financial derivatives among non-financial end-users from 1987 to 2017. I argue that, even if in some cases derivatives exhibit certain characteristics that set them apart from most mainstream assets (leverage, complexity, payoff asymmetry), the results of this analysis do not support most of these criticisms. First, all the derivatives products in our sample performed as expected and all the losses were the result of wrongly timed market strategies (Chapter III). There were no losses due to operational or legal reasons (which we assume are to be expected if the products were arcane). The analysis shows that, even if some products were complex and volatile, they cannot be considered opaque or impenetrable. Indeed, the mark-to-market of certain products in our sample reached extreme levels, but volatility of results is a consequence of market risk, not necessarily cryptic structures. It appears that financial managers took the wrong market views and lost. We will see that in all cases, the products performed as they were designed to perform. In the overwhelming majority of cases, these strategies were deliberately not designed as “bona fide” hedges but were oriented towards attaining off-market rates or extraordinary returns at no upfront cost for the users. (I call these strategies “speculative hedging.”) This could only be obtained by taking additional risks. Financial managers used the flexibility allowed by derivatives to improve prevailing market conditions: exporters raised their FX conversion rates, importers reduced them, borrowers lowered the cost of their debt, etc. Derivatives were used to achieve additional goals beyond “bona fide” hedging. This fact contrasts sharply with the mainstream usage of derivatives as hedging tools (see Chapter IV). In Chapter V, I argue that, given their academic background, it is indeed likely that most end-users did not fully grasp the math behind the most complex strategies, which would validate one of the most common criticism about derivatives. On the other hand, the financial executives in our sample seemed to understand the risk/return trade-offs of their strategies since they agreed to take additional market risks in order to achieve off-market rates with no upfront cost. Moreover, having a deep understanding of derivatives was not a guarantee of success. Some of the executives responsible for the largest losses in our sample had mathematical and/or advanced finance backgrounds. Despite the fact that derivatives have consistently been blamed for their opaqueness, half of the cases happened with simple products (either forwards or “plain-vanilla” swaps and options). Additionally, in our sample, complexity is not a valid indicator of the magnitude of the losses. Three of the largest losses were caused by simple currency forwards. Finally, I argue that a key determinant of the sample’s derivatives losses is based on the fact that financial managers flagrantly underestimated the likelihood of extreme market events (Chapter VI). Generally, these losses happened after a period of persistent market trends: falling interest rates in the early 1990s, rising interest rates in the mid-2000s, and strengthening local currencies before 2008. Financial managers believed recent market trends would continue for the foreseeable future and overlooked the risk of extreme and unexpected market moves  interest rates falling down to almost zero in 2008, the Federal Reserve hiking rates 6 times in less than a year in 1994, or local currencies depreciating by thirty or forty per cent in 2008.