Rogue traders like Nick Leeson have been a part of of the financial landscape for years. Leeson was the young trader who destroyed Barings Bank in the early 1990s. That was the UK equivalent of Bear Stearns disappearing over a weekend. Shortly after that, Orange County, California faced a similar billion dollar loss through derviatives trading.Derivatives Trading Defined
Most personal investors never have to worry or learn about derivatives, but you should be paying attention if your financial advisor or fund is using them as a hedge. At their core, derivatives are a financial instrument investors use to hedge their investment or even to bet against a market's general direction.
Derivatives usually involve a commitment to buy or sell a certain investment at a future date at a currently agreed upon price. Those investments can be anything from stocks to currency against another currency to a commodity.
If you saw the Eddie Murphy and Dan Akroyd movie Trading Places, released a generation ago, the orange juice futures being traded were essentially a derivative. And while you may not find a public exchange trading orange juice futures, you can certainly find public exchanges trading oil, gold and even soybean futures.
Because these trades are often made on margin (remember the margin call at the end of the movie), derivatives are a fast way to lose a lot of money while putting up only a fraction of the amount.
Why Derivatives Are Important Now
A billion dollars is the new million say many big investors so a headline of a trader causing a billion dollar drop doesn't necessarily destroy an institution any more.
During the beginning of 2008, however, France's Societe General (also called SocGen) announced that a young trader without authorization had dummied records and plunged the bank into the derivatives market while losing more than $7 billion.
The crisis reverberated through the financial and political communities. French officials were outraged that a 145 year old legendary institution was teetering on the brink of failure. No one understood how a 31 year old non-executive trader could enter derivative trades greater than the value of SocGen's market capitalization.
New reports out this weekend suggest that the trader, Jerome Kerviel, may have had at least one accomplice at a more senior level.
Given the relatively easy going Kerviel has experienced, we always wondered how far up SocGen's ladder the trading was known. The coming weeks will undoubtedly prove challenging for the bank and indeed for European institutions. If Countrywide and CDOs are the poster children of the financial crisis in the US, SocGen's $7 billion derivatives loss may be Europe's.
Why do derivatives matter to you as an individual investor? Because you need to know how much risk you are willing to assume and then you need to see what your funds and other investments are doing in the derivatives market.
One celebrity investor who isn't going anywhere near the derivatives pool is Warren Buffett. The renowned investor told Reuters (as published in today's New York Times) that "It's not right that hundreds of thousands of jobs are being eliminated, that entire industrial sectors in the real economy are being wiped out by financial bets even though the sectors are actually in good health."
We agree with Warren. We usually do. And on this long weekend, you should see how much of your own investments are tied up in this high risk-high reward area.
Labels: Buffett, derivatives, Societe General
