December 10, 2005. Bharat Arora sits in a smoke filled room in front of his PC in an obscure town in India busily tracking derivatives’ in the global market. A Phd in music, Arora applies the music theory to make money in derivatives' trading. It may sound ridiculous, but yes he believes that the indices have to move randomly but in a pattern based on scales. Like every scale, the index has a root note that is associated to a particular risk.

Based on a major or minor scale, the risks of the index can be carefully gauged. Since there are hundreds of scales, at any given point of time, indices have to fit into one scale or the other. He also believes that with a risk pattern based on scales, hedging could effectively be made into a zero sum game.

If he succeeds, well and good. Interestingly, it he fails he joins the esteemed (rogue) gang of Nick Leeson, Hamanaka or for that matter even Scholes.

The characteristic feature of this trader is that the senior management of his firm does not have the slightest idea about the technique and instrument that he is using to value complex derivatives. A case identical to Barings, the oldest British bank, which collapsed not knowing the futures trading methodology used by their employee Nick Leeson. The bank crumbled following Leeson's bets on the movement of the Japanese Nikkei-225 stock index which led to colossal losses of $860 million.

It all started in 1992 when Barings Plc., a highly regarded British banking firm, hired Nicholas W. Leeson and installed him at its small office in Singapore. He was making significant profits on tiny differences (arbitrages) between the prices of financial instruments in Japan and Singapore. In January 1995, for reasons still not fully understood, Leeson abandoned the strategy of matching the prices of derivatives and began trading in them directly and indulged in making large purchases of futures on the Japanese stockmarket.

But, these turned bad. In his bid to cover his losses and hedge his bets he made further purchases . But neither his purchases nor his strategy bore the desired results.

And by February, the margin calls reached alarming levels and required him to put up large amounts of cash to cover the options. The result, the bank had to shut down.

Ironically, the management had failed to sense the trouble in the early stages because Leeson was in total control of both the dealing room and the back office operations. Hence the reason why the mounting losses went unnoticed with not even a single bank official getting a whiff of the goings on at their Singapore office.

But, when things went overboard the ripple effects were felt at all the leading markets. Stocks fell sharply at the New York, London and, the Japanese markets. These recovered somewhat when it was realised that the Barings loss effect was not snowballing.

Hamanaka’s nightmare
The Barings fall was not the end of it. A year later, another trader who smartly manipulated the copper prices on the LME managed an even bigger financial disaster with the losses put at $1.8 billion (rumoured to be around $4 billion).

Understanding what exactly happened in the Sumitomo crash is something that includes strenuous details. To put it simply, Hamanaka, the Sumitomo trader, accumulated all the copper at the London Metal Exchange (LME). The incident could be likened to that of a local Baniya hoarding all the onions produced and then dictating a high price on his own. The only difference being that the local baniya would have collected the onions physically, while Hamanaka purchased the copper in the futures market at the LME.

Beginning in late 1993, Hamanaka entered into a series of agreements with a newly formed US copper merchant firm located in New York City. As per the agreements, Sumitomo agreed to purchase copper from the American firm on a monthly basis for the years 1994 through 1997.

The supply contracts were sealed at unusually minimum prices and price participation provisions.

In the fall of 1995, Sumitomo's copper trader authorised 100 per cent acquisition of the LME warehouse stocks by Sumitomo. And, the US copper merchant set out the instructions for managing this large portfolio of futures positions taken by Sumitomo.

Pursuant to the plan, beginning in late October 1995, Sumitomo, through its copper trader, rapidly increased its ownership and control of LME deliverable warehouse stocks. By November 24, 1995, Sumitomo owned 93 per cent of all LME warehouse stocks through one brokerage house alone.

Combined with holdings at other brokerage houses, Sumitomo together with the US copper merchant owned and controlled up to 100 per cent of LME stocks (including in the LME warehouse in Long Beach, California) at various times in the fourth quarter of 1995.

For the smooth running of the operation, it was necessary for Sumitomo to take some loss on the supplies that were withheld from the market to sell them later at lower prices. This loss would have been far smaller than the gain from the prevailing higher prices.

There were at least a few others including George Soros who believed that Sumitomo was keeping the prices at artificial levels and thought that the prices would fall in the future and, copper would be speculated.

But, Hamanaka refused to buzz in supplies which could have raked in the moolah for him. Greed got the better of the supposedly smart trader. The result, Sumitomo plunged into losses running into billions of dollars.

nese appetite
These days speculation in metals is immense. This was the case earlier though at lower levels. But there are instances when certain trades in pure speculation has left the trader, sometimes trader countries,in a mess.

Take the case of China. The country went short by 2,50,000 tonnes (that is the entire demand from India) on zinc in the futures market when the LME price was $1,400 in mid-1997. Even a metal like zinc came under crazy speculation.

What China did at that point of time was nothing out of the ordinary. The zinc prices were prevailing at their seven-year highs. China itself had a production of 6,48,000 tonnes besides accounting for 15 per cent of the world’s production and 9 per cent of the world's zinc consumption.

Consequent to the speculation activity, a mine got shut down and prices spiralled to touch an all-time high of $1,600 per tonne. Canada's leading Anvil Range's Corp's Faro mill having a capacity of 180 million tonnes per annum, also shut down. Though China managed to deliver the metal, the country was faced with rough times.

Thus, though one can go on endlessly about "betting on the wrong side of derivatives", as a fund manager rightly said, a derivative is like a gun. One can either protect oneself or could kill another. In many cases it is suicidal.

Long-term mismanagement
Hedge funds, which use derivative to bet on both sides of the wager sometimes die a sad death. There around 4,500 funds of this type floating with assets amounting to $300 billion. But sadly, not much data i s available about the operations of these hedge funds

A case in point would be the Long Term Capital Management (LTCM) story. Long Term had nearly $1 trillion by way of bad investments as against a meagre $2 billion in assets.

Usually, 81 per cent of the funds borrow and most borrow just under five times their asset base. Imagine being able to take a mortgage for five times the value of your home! No bank would do it -- yet they do it for the hedge funds.

The LTCM fund was managed by some of the biggest names on the Wall Street, including three former Salomon Brothers' brokers and two Nobel prize-winning economists, Robert Merton and Myron Scholes.

The search to find a way to price the option contracts began seriously when the thesis of an unknown student named Louis Bachelier was unearthed in the 1950s. Using a series of equations he had created the first complete mathematical model of the markets.

He had found out that the stock prices moved at random and that it was impossible to make exact predictions about them. Bachelier also claimed to have found a solution through the pricing of a financial contract called an option.

On the bourses the risk is, if one buys a stock today the price could drop in the future and one could lose money. But, with an options contract one can wait and buy the stock when it reaches the agreed price in the future. There's no obligation though. On the other hand, if the stock doesn’t reach that price one could always opt out and one would have only lost the cost of the option.

But how does one price this option? This is where Sholes and Black put minds together to work out a solution. The only problem was that the markets were too fast to price these options. Bob Merton joined hands and applied ideas from rocket science to constantly recalculate risks. Unfortunately this model was based on normal markets and failed to weave in the intricacies of the global markets.

Derivatives can be summed up in two words: running numbers. Although the risk is very high, if betted on correctly, derivatives could pay off big-time (if the markets remain stable). But currently, the global markets have deflated and the hedge funds are losing out.

For instance, LTCM's investments were mainly bets made the global bond markets. Not content with just owning bonds and collecting the interest amount, the fund hedged its bets by betting those bonds with credit risk on the premise that they would do better in terms of price when compared with the European government bonds and US Treasuries.

The fund further hedged by buying stocks in emerging markets. Stocks usually rise when the bond prices decline. LTCM sought to make a profit no matter where the prices moved.

But, when the Asian financial crisis occurred, emerging market stocks lost much of their value. And when Russia defaulted on its domestic debt, emerging market bond prices also fell against the US and European bonds. LTCM lost both ways.