Chapter 1: Primer on Derivatives 1 What Are Derivatives? 1 Who Buys and Sells Derivatives? 2 Where Are Derivative Contracts Bought and Sold? 2 Two Major Types of Derivatives 3 Forward Contracts 3 Option Contracts 4 Forward Contracts 4 Long Forward in Action 5 Short Forward in Action 6 Options 7 Call Options 7 Put Options 8 American versus European Options 9 Examples of Puts and Calls in Action 9 4,000 Years of Derivatives 13 Conclusion 14 Risk Notepad 1.1: OTC-traded versus Exchange-Traded Derivatives 15 Review Questions 18 Bibliography 19 Chapter 2: Employee Stock OptionsA User''s Guide 21 ESOs: A Major Pillar of Executive Compensation 21 Why Do Companies Use ESOs? 22 Aligning Incentives 22 Hiring and Retention 23 Adjusting Compensation to Employee Risk Tolerance Levels 24 Employee Tax Optimization 24 Cash Flow Optimization 25 Option Valuation Differences and Human Resource Management 26 Problems with ESOs 37 Employee Motivation 38 Improving Performance 40 Absolute Versus Relative Performance 40 Possible Solutions to Employee Stock Option Problems 41 Premium-Priced Stock Options 41 Index Options 42 Restricted Shares 45 Omnibus Plans 45 Conclusion 46 Review Questions 46 Bibliography 47 Chapter 3: Metallgesellschaft AG Illusion of Profits and Losses, Reality of Cash Flows 51 Metallgesellschaft: Evolution of the Company and Its Product Lines 51 Energy Derivatives at MGRM 52 Energy Markets on a Roller Coaster 53 Risk Notepad 3.1: What Is the Difference Between Contango and Backwardation? 55 MGRM''S Innovative Energy Derivative Products 56 MGRM''s Embedded Options 58 Hedging MGRM''s Forward Energy Exposures 59 Payoff Profile of a Short Forward Position 59 The Ideal Hedge Was Not Available 61 Physical Storage Hedge 61 Stack-and-Roll Hedge 62 Cash Flow Effects of a Stack-and-Roll Hedge 64 Scenario #1: The Price of Oil Falls and Basis Falls for Two Consecutive Months 65 Stack-and-Roll Hedge Ratios 69 MG Calls It Quits 69 MGRM Butts Heads with NYMEX and the CFTC 70 MGRM''S Profitability: It''s All in How You Account for It 71 MGRM''S Credit Rating 72 The Effects of an Itchy Trigger Finger 72 Was MGRM Hedging or Speculating? 72 Corporate Governance Issues 73 Conclusion 74 Review Questions 75 Bibliography 76 Chapter 4: Swaps That Shook an Industry: Procter & Gamble versus Bankers Trust 77 P&G''s Motivation for the Swaps 78 Motives for the U.S. Dollar-Denominated Interest Rate Swap 79 Motives for the German Mark-Denominated Interest Rate Swap 80 Motives for Using the Over-the-Counter Market 80 The U.S. Dollar-Denominated Swap 81 Plain Vanilla Swap 82 P&G''s Gamble: The Speculative Side-Bet 83 Viewing P&G''s Speculative Side-Bet as a Short Call Option 84 Risk Notepad 4.1: Security Yield versus Price 86 The Effect of Rising U.

S. Interest Rates 87 Losses on P&G''s U.S. Dollar Interest Rate Swap 91 German Mark-Denominated Interest Rate Swap 93 The Suit against Banker''s Trust 95 Risk Notepad 4.2: Value at Risk 97 The P&G-BT Settlement 98 How Did BT Fare After the Swaps? 98 P&G-BT from an Investor''s Perspective 99 The Landmark P&G-BT Court Opinion 100 Major Legal Issues 100 An Unusual Court Opinion 101 Summary of the Court Opinion 102 Disclosure Reform after P&G-BT 102 Should Corporate Treasuries Be Profit Centers? 103 Conclusion 103 Review Questions 104 Bibliography 105 Appendix 4.1: What Is an Interest Rate Swap? 107 Chapter 5: Orange CountyThe Largest Municipal Failure in U.S. History 109 Robert Citron and the Orange County Board of Supervisors 109 The Orange County Investment Pool 112 The Major Risks Facing Assets in the OCIP Portfolio 114 Credit Risk 115 Market Risk 115 Liquidity Risk 116 OCIP''s Assets and Funding Sources 117 Structured Notes 118 Risk Notepad 5.

1: Other Assets in the OCIP Portfolio 118 Fixed-Income Securities 120 OCIP''s Funding Sources 120 Leveraging the OCIP Portfolio 123 Effects of Leverage on OCIP''s Return 124 OCIP''s Rising Returns: Effects of Falling Interest Rates 124 OCIP''s Return Stabilizes: 1993 126 OCIP''s Returns Plummet: 1994?Effects of Rising Interest Rates 127 The Consequences 128 Market Risk Causes Liquidity Risk 129 Government Paralysis 130 Citron Resigns 130 Lack of Liquidity Leads to Bankruptcy 130 Fire Sale of the OCIP Portfolio 131 Monday-Morning Quarterbacking 131 Was Orange County Truly a Derivative-Related Failure? 131 Was Orange County Really Bankrupt? 133 Was It a Mistake to Liquidate the OCIP Portfolio? 134 Could the Debacle Have Been Predicted? 135 Sentences, Blame, and Reform 136 Robert Citron 136 Other Players: Matthew Raabe and Merrill Lynch 137 Stealth Supervision: Shared Blame 138 Governance Reforms 139 Lessons Learned from Orange County 139 Safety, Liquidity, and High Yield Are an Impossible Combination 139 If You Can''t Explain It, Then Don''t Do It 140 Conclusion 141 Review Questions 141 Bibliography 142 Chapter 6: Barings Bank PLCLeeson''s Lessons 143 Barings Bank PLC 143 Nick Leeson: From London to Jakarta to Singapore 144 What Was Leeson Supposed to Be Doing at BFS? 145 Risk Notepad 6.1: What Are Stock Indices and Stock Index Futures Contracts? 147 Five Eights Account 148 Risk Notepad 6.2: Errors Accounts 149 Leeson''s Trading Strategy: Doubling 150 Risk Notepad 6.3: Doubling 152 Funding Margin Calls 153 Funding Source #1: Increasing Commission Income by Offering Deals at Non-Market Prices 153 Funding Source #2: Using the Financial Resources of Barings as His Cash Cow 154 Funding Source #3: Booking Fictitious Trades and Falsifying Records 155 Funding Source #4: Selling Options 156 Risk Notepad 6.4: Leeson''s Most Flagrant Falsification Scheme 156 Net Profit/Loss Profile of Leeson''s Exposures 157 Leeson''s Long Futures Positions 157 Leeson''s Short Straddles 159 Profit/Loss Profile: Combining One Short Straddle and One Long Futures Contract 161 Profit/Loss Profile: Combining a Long Futures Position and "Numerous" Short Straddles 162 Massive Purchases of Nikkei 225 Futures Contracts 163 Beyond Irony: The Barings Failure in a Broader Time Frame 164 A Bank for a Pound 165 Aftermath of the Barings Failure 167 How Could Barings Have Caught Leeson Sooner? 168 Conclusions 171 Review Questions 172 Bibliography 173 Chapter 7: Long-Term Capital Mismanagement"JM and the Arb Boys" 175 Risk Notepad 7.1: What Is a Hedge Fund? 176 LTCM: The Company 177 The LTCM Business 177 The Principals 177 LTCM''S Strategy 179 Identifying Small Market Imperfections 179 Using a Minimum of Equity Capital 180 Securing Long-Term Funding 184 Charging Hefty Fees 186 LTCM''S Impressive Performance: 1994-1997 186 LTCM''S Contributions to Efficient Markets 189 Why and How LTCM Failed 190 Catalyst #1: Exogenous Macroeconomic Shocks 190 Risk Notepad 7.2: What Is Contagion? 192 Catalyst #2: Endogenous Shocks 193 The Fed, Warren Buffett, and the Rescue of LTCM 198 Risk Notepad 7.3: Another Look at Warren Buffett''s Offer for LTCM 200 Conclusions and Lessons 202 Be Careful What You Wish For 203 Beware of Model Risk 203 All for One and "1" for All 203 Leverage Is a Fair-Weather Friend 204 Financial Transparency Is.