“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Berkshire Hathaway Inc. Chairman of the Board Warren Buffet, “Letter to the Shareholders of Berkshire Hathaway Inc.,” February 21, 2003 Since the early 1990’s, there have been a number of high profile businesses that have realised huge losses associated with the use of derivatives for hedging that went wrong. Better known cases in the 1990’s involved Barings Bank (195), Long Term Capital Management (1998), Procter and Gamble (1994), Metallgesellschaft AG (1993), and Orange County California (1993) whilst more recent cases include JP Morgan (2012), AIG (2008) and China Aviation Oil (2004).

QUESTION

PART 1: (40 marks)

“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Berkshire Hathaway Inc. Chairman of the Board Warren Buffet, “Letter to the Shareholders of Berkshire Hathaway Inc.,” February 21, 2003

Since the early 1990’s, there have been a number of high profile businesses that have realised huge losses associated with the use of derivatives for hedging that went wrong. Better known cases in the 1990’s involved Barings Bank (195), Long Term Capital Management (1998), Procter and Gamble (1994), Metallgesellschaft AG (1993), and Orange County California (1993) whilst more recent cases include JP Morgan (2012), AIG (2008) and China Aviation Oil (2004).

You are required to choose one of the above cases. In relation to your chosen case, answer the following questions:

1. (i)  Describe the facts, including background (nature of company business, trading history, size, etc.) and nature and amount of losses realised;
2. (ii)  Explain the risk that the company was subject to and detail Risk Management (RM) techniques that were used. Please note any specific derivatives hedging strategy.
3. (iii)  Explain what went wrong in detail;
4. (iv)  Evaluate the RM performance; and detail any lessons learned from the experience.

PART 2: (60 marks)

Choose one of the following two cases and answer the questions relating to your case of choice. Case readings are available from Moodle. You are encouraged to conduct your own extra research to answer the questions.

CASE 1: HEDGING AT PORSCHE

Porsche, a German manufacturer of performance cars, was known for a cautious approach to risk management and conservative financial policies. In 2007, however, it stunned analysts and investors by reporting billions of dollars of profits from transactions on financial derivatives. Some of these profits came from foreign exchange hedging, but much of them were due from a huge position in options on Volkswagen stocks. Volkswagen, one of the world’s largest car manufacturers and a company many times the size of Porsche, was partnering with Porsche on a number of development and manufacturing projects.

Porsche used the option to build an ownership stake in Volkswagen. Porsche argued that the ownership stake was necessary to prevent a hostile takeover and breakup of its key partner by a third party. Porsche’s executives further maintained that the options strategy to build the stake was prudent because it protected Porsche against the risk of a substantial rise in Volkswagen’s stock price once Porsche’s intentions became clear to market participants. However, critics argued that Porsche’s derivatives transactions represented reckless speculation that could put the entire company at risk.

Answer the following questions relating to the case.

(i) Should Porsche hedge its foreign exchange exposure? How do Porsche competitors, such as BMW, deal with this risk? Can Porsche do something similar?

(ii) Research Porsche’s option hedging strategy and describe it in detail. What would be an alternative hedging strategy? Which strategy is better for Porsche?

(iii)How did Porsche build its Volkswagen stake? Why not buy Volkswagen stocks directly?

(iv) Was Porsche’s attempt to build a stake in Volkswagen a sensible one? Or do you agree with critics who argued that Porsche was speculating with shareholders’ money and it had become a hedge fund that neglected its core business? Justify your answer.

CASE 2: FUEL HEDGING AT JETBLUE AIRWAYS

Traditionally, airlines cross-hedge their jet fuel price risk using derivatives contract on other oil products such as WTI and Brent crude oil. Consequently, an airline is exposed to basis risk due to asset mismatch.

Please use the case “2010 Fuel Hedging at JetBlue Airways” (available for download from Moodle) and your extra research to answer the following questions.

1. (i)  Should JetBlue Airways hedge its fuel price risk? Compare and contrast JetBlue’s approach to managing its fuel price risk to other US airlines.
2. (ii)  Given the high price of jet fuel at the end of 2011, should JetBlue hedge its fuel costs for 2012? And, if so, should it increase or decrease the percentage hedged for 2012?
3. (iii)  Explain the concept of cross-hedging and the basis risk that results from cross-hedging. Should JetBlue continue using WTI as an oil benchmark for its crude oil hedges or switch to Brent? Justify your answer using the provided data.
4. (iv)  What alternative Risk Management techniques could JetBlue Airways have used?

ANSWER

Long Term Capital Management (LTCM): Risk Management Lessons from a Hedge Fund Collapse

Introduction

The collapse of Long Term Capital Management (LTCM) in 1998 sent shockwaves through the financial world, exposing the dangers of inadequate risk management and excessive leverage. LTCM, founded by renowned economists and Nobel laureates, aimed to profit from relative value arbitrage strategies in fixed-income markets. However, the fund’s downfall serves as a cautionary tale about the potential risks associated with derivatives and the importance of robust risk management practices.

(i) Facts and Background

LTCM, founded in 1994 by John Meriwether, managed billions of dollars in capital and held over $1 trillion in notional value of financial derivatives. The firm attracted top talent, including economists Myron Scholes and Robert C. Merton, who developed the Black-Scholes-Merton option pricing model. LTCM engaged in complex strategies, such as convergence trades, to exploit pricing discrepancies in various markets.

(ii) Risk Management Techniques and Derivatives Hedging Strategy

LTCM implemented risk management techniques like value-at-risk (VaR) models and diversified its portfolio across multiple asset classes. To hedge its positions, the fund extensively used derivatives such as interest rate swaps, currency swaps, and options. It employed a convergence trading strategy, which involved taking offsetting positions in mispriced securities.

(iii) What Went Wrong

LTCM’s downfall can be attributed to several factors. First, its models failed to account for extreme events and underestimated the correlations among different markets. When the Russian financial crisis hit in 1998, panic ensued, causing sharp increases in market volatility and liquidity drying up. LTCM’s positions became illiquid, amplifying losses that were difficult to unwind. Excessive leverage further intensified the impact of the losses, pushing the fund to the brink of insolvency.

(iv) Evaluation of Risk Management Performance and Lessons Learned

LTCM’s risk management performance faced severe criticism for its failure to anticipate and mitigate the risks associated with extreme market events. Relying solely on complex mathematical models proved inadequate, highlighting the need for stress-testing assumptions and accounting for tail risks. The fund’s heavy leverage compounded the losses and underscored the importance of conservative leverage ratios.

The LTCM case served as a wake-up call for regulators and market participants. It emphasized the need for stricter risk management practices, including enhanced risk monitoring, deeper understanding of liquidity risks, and more conservative leverage ratios. Recognizing the potential systemic risks posed by highly leveraged hedge funds, regulators implemented measures to strengthen risk oversight and coordination between financial institutions.

Conclusion

The collapse of Long Term Capital Management serves as a stark reminder of the risks associated with derivatives and the importance of robust risk management practices. LTCM’s failure exposed the limitations of relying solely on mathematical models and the need for stress-testing assumptions. The lessons learned from this case continue to shape risk management practices in the financial industry, emphasizing the significance of prudent risk assessment, conservative leverage, and a comprehensive understanding of liquidity risks.

References

Forbes: “Lessons from the Collapse of Hedge Fund, LTCM.” (https://www.forbes.com/sites/bryceelder/2018/09/24/lessons-from-the-collapse-of-hedge-fund-ltcm/?sh=6d34d3bb62cc)

Investopedia: “The Failure of LTCM: A Case Study.” (https://www.investopedia.com/financial-edge/0211/the-failure-of-ltcm-a-case-study.aspx)

Federal Reserve History: “Long-Term Capital Management.” (https://www.federalreservehistory.org/essays/long-term-capital-management)