SocGen and derivatives

I was having my afternoon coffee in T3 (Changi Airport), reading the Financial Times. The headline is of course the Euro 4.9 billion loss by one single trader (Mr. Jerome Kerviel, a harmless looking chap) in Societe Generale. I was curious to know how did this come about, and what lesson can be learnt from this case. First, what went wrong?

The problem came from equity derivatives. What exactly is equity derivatives?

In the world of investment, we have basically 3 groups of investment products. The first group is the traditional products such as shares and bonds. The second group is the non-traditional products such as hedge fund, REITs, commodities, currencies, arts and private equity. The thrid group consists of financial instruments such as futures, options and swaps. The third group is commonly known as derivatives.

A derivative is a financial contract between 2 or more parties, which is derived from the future value of the underlying asset. As in most financial products, it started life innocently. It is a way where manufacturers can hedge the volatile prices of raw materials or currencies, so that the production (and financial) process can be executed meaningfully in a predictable manner. As in most financial products, it loses its innocence fairly quickly when speculators step in.

Over the years, derivatives have become a way where people and institutions trade for big profit (and loss). I was flipping through the pages of Financial Times, I found that practical everything can form the underlying asset of a derivative. We have bond futures, interest rate futures, oil futures, commodities futures, Euorpean stock index futures, and the list go on and on.

In a future contract, the buyer and seller enter into a firm contractual agreement for a specified asset on a fixed date in the future. Usually the buyer need only come out a fraction of the contract price (call the margin), and when the fixed date is due, the full amount has to be settled. The problem is that one can never know what this future price will be. As a result, most traders are merely "betting" the price movement. The problem can be further magnified if the trader uses leverage (i.e. borrow money) to execute his bet.

In Societe Generale's case, the bet went way off in series, and the loss amounted to euro 4.9 billion, which essentially wipe out the entire pretax earning of the bank for the year!

Prior to this case, Societe Generale prides itself to have a world-class equity derivatives business under the leadership of its chairman, Mr. Daniel Bouton, since 2000 (SocGen hires most of the best mathematicians produced under the French education system). This case demonstrates that we have to respect the uncertainty nature of the economic market, and be very prudent when handling complex products. Otherwise, that very product can be a "weapon of mass destruction" inflicting huge pain onto the user, even if the user is first class.