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Derivatives
- 1. GROUP MEMBERS : SUNITAMUDULI SUSHMITA BASAK RUPAL PATEL AISHWARYA KULKARNI KSHIPRA LAKSHMAN LESSONS FROM THE SUMITOMO COPPER DERIVATIVES DISASTER
- 2. USEFUL INSTRUMENTS ORWEAPONS OF MAS DESTRUCTION ?
- 3. HOW IT BEGAN… Sumitomo Corp. was one of the top five “Sogo-Shosha”, general trading companies in Japan. Yasuo Hamanaka (called as "Mr. Five Percent” & "Mr. Copper”) was the head of copper trading at Sumitomo prior to 1996. Sumitomo Corp. was speculator until late 1980’s. It acquired mines in the Philippines in 1984, which changed its position from speculator to supplier. His main strategy was the “short squeeze”. He was buying futures and choosing physical delivery . He stored it in the warehouse, thereby creating lack of copper in the market. Future sellers ended up buying copper in a spot market, resulting in backwardation: the spot price is higher than the forward price. He sold put options to collect the premiums as he thought he can push the prices up, thus writing put options was not risky for him.
- 4. THE TRAP… InDecember of 1991, LME decided to set new regulations that would limit the range of backwardation within 25 pounds to prevent market manipulation. It a huge loss in Sumitomo’s portfolio. To recoup the loss, he conducted a Radr transaction in June 1993.
- 5. $ 1900 $2140 1st: In June 25, 1993 • bought call option @ price of $2,400 -expire after 2 years. • Total volume 1 million metric tons compared LME inventory of 0.5 million • The portfolio could make a profit if the price went up to $2,480. • To pay a premium of $69 million, Hamanaka made a 2nd trade. 2nd: He made a short strangle, • Write 0.5 million @ $2,100 call option. • Write $1,900 put option. • The portfolio could make a profit if the price remained between $1,900 and $2,140. • From this transaction, he got $94 million of premium and paid for the 1st option. • With 1st and 2nd strategy, total breakeven was $2,700. Radr transaction steps :
- 6. 3rd: • Selling future@ $2,000 • which increased payoff to around $1,900. 4th: • Buying 1.35 million metric tons @ $1,750 put • breakeven was $1,580 • He predicted that the copper price would go down below $1,600 level. 5th: • Buying 1.35 million metric tons @ $1,800 put again • breakeven was changed to $1,680. • This could make a profit slightly if the price went down below $1,700 level. 6th: • write 1.2 million metric tons of $1,950 call to get $29 millions of premium. • With this transaction, breakeven was changed to $1,680. • However, if the copper price exceeded $1,950, suffered a huge loss. LME, however intervened again to avoid market domination by setting new rules that limited backwardation within $5, and, to increase market control, LME forced Credit Lyonnais Rouse, a major counterparty of Sumitomo Corporation, to reduce its positions. Based on these regulations and changes, Sumitomo ended up closing their Radr position and incurred a $1.1 billion loss.
- 7. THE FINAL BLOW… The market conditions changed in 1995, with resurgence of mining in China. increase in the supply put more pressure on the market for a correction. The company was left in a bind because it still was long on copper when it was heading for a big drop. Worse yet, shortening its position - that is, hedging with shorts - which would simply make its significant long positions lose money faster, as it would be playing against itself. While Hamanaka was struggling over how to get out with most of the ill- gotten gains intact, the LME and Commodity Future Trading Commission (CFTC) began looking into the worldwide copper-market manipulation.
- 8. AFTERMATH OF THESCANDAL Sumitomo responded to the probe by "transferring" Hamanaka out of his trading post. Copper plunged, and Sumitomo announced that it had lost over $1.8 billion, and the losses could go as high as $5 billion, as the long positions were settled in a poor market. They also claimed Hamanaka was a rogue trader and his actions were completely unknown to management. Hamanaka was charged with forging his supervisor's signatures on a form and was convicted for 7 years. Sumitomo responded to the allegations by implicating JPMorgan Chase and Merrill Lynch. Sumitomo blamed the two banks for keeping the scheme going by granting loans to Hamanaka through structures like futures derivatives. All of the corporations entered litigation with one another, and all were found guilty to some extent.
- 9. LESSONS LEARNT Management-Levelcontrol: Sumitomo Corporation failed to execute a consistent management job rotation policy. His dominant position in the copper market made him untouchable inside the corporation as well as outside and no one dared to look closely at his transactions. Independent Transaction Monitoring: Sumitomo should have created a separate and independent supervisor system within the company hierarchy to avoid these agency issues. In fact, after 1996, many governmental agencies, including ones in Japan, established new rules that provided that the middle and back office should be totally separated from the front office. Corporate Responsibility: We should also consider corporate responsibility with regard to timely reporting. In the Sumitomo case, the management waited ten days until issuing a press release. It could have avoided additional declines in copper prices that were caused because of the rumors and uncertainty in the market.
- 10. LME Regulation:Copper could not easily be transferred around the world to meet shortages. The arbitrage opportunity in price differences could be easily offset by additional delivery and storage costs. Government Regulation: The regulatory agency should have executed more stringent rules on the derivatives market to avoid price manipulation and impose new regulations on corporate reporting obligations so as to provide investors and other market participants with greater information regarding the organization’s willingness to take risks and capability to manipulate market prices.
- 11.
Editor's Notes
- #4 Sumitomo Corp. under the Sumitomo group, is one of the top five “Sogo-Shosha”, general trading companies in Japan. Only five out of 11,000 trading companies are classified as Sogo-Shosha in terms of trading volume. It contributes approximately 10% of the gross margin of Sumitomo. Yasuo Hamanaka was the head of copper trading at Sumitomo prior to 1996. "Mr. Five Percent" because he traded approximately 0.5 million metric tons per year which was 5% of total world demand & tried to dominate the copper market by increasing volume. also known as "Mr. Copper“, due to over 23 years experience in copper trading Due to pressure of generating $10 million annual revenue from Sumitomo’s traditional copper business, he made off the book deals to recoup his unrealized losses. Malfunctions in the control process & segregation of duties allowed him to keep two sets of trading books - one showing big profits for Sumitomo and a second, secret account, that recorded unauthorized trades for over 10 years.
- #5 A Radr transaction is an extremely large transaction compared to the market size and aims to achieve a profit, even with a declining price.
- #7 Radr transactions In December 1991, the LME announced new regulation about backwardation, which limited the price between the spot and forward to 25 pounds, thus expanding Sumitomo’s loss. Hamanaka tried to recoup the loss by increasing the trade volume and made a contract with Winchester for1 million metric tons over two years at the price of $2,800, however, due to price declines, the loss kept expanding. Hamanaka’s next step was to create an option portfolio named “Radr” transactions. He made six different transactions in Radr. The counterparty of these transactions was Credit Lyonnais Rouse (“CLR”, currently Calyon Group). Since the position held by CLR was large and caused backwardation, LME tightened the backwardation limit to $5 in September 8 1993. In addition, LME informed Credit Lyonnais that they were to cancel part of their transactions with Sumitomo on September 17th,, Thus resulting in a $1.16 billion loss for Sumitomo. The following are the details of the aforementioned transactions and Appendix 3 provides for the payoffs of Radr. Appendix 2 provides that the future price when Hamanaka placed the order was $1,900 and remained stable until September 8th. After the new regulation was released, the price went down slightly to $1,600, as Hamanaka expected. If there had not been a regulation change, Hamanaka would have recovered his loss. 1st: In June 25, 1993, Hamanaka buys call option with an average price of $2,400 and which expires after 2 years. The transaction is totally irregular because the total volume was 1 million metric tons as compared to all LME inventory of 0.5 million. The portfolio could make a profit if the price went up to $2,480. To pay a premium of $69 million, Hamanaka made a 2nd trade. 2nd: Hamanaka made a short strangle, combination by selling a 0.5 million $2,100 call and $1,900 put option. The portfolio could make a profit if the price remained between $1,900 and $2,140. From this transaction, he got $94 million of premium and paid for the 1st option. With 1st and 2nd strategy, total breakeven was $2,700. 3rd: Selling future at a price of $2,000 which increased payoff to around $1,900. 4th: Buying 1.35 million metric tons of $1,750 put, breakeven was $1,580. He predicted that the copper price would go down below $1,600 level. 5th: Buying 1.35 million metric tons of $1,800 put again, breakeven was changed to $1,680. This portfolio could make a profit slightly if the price went down below $1,700 level. 6th: Selling 1.2 million metric tons of $1,950 call to get $29 millions of premium. With this transaction, breakeven was changed to $1,680. However, if the copper price exceeded $1,950, Sumitomo suffered a huge loss.
- #10 Management-Level control: Sumitomo Corporation failed to execute a consistent management job rotation policy. His dominant position in the copper market made him untouchable inside the corporation as well as outside and no one dared to look closely at his transactions. Superstar employees exist in every corporation. However, to permit exceptions for these employees creates the wrong atmosphere. Setting up corporate discipline and a sound management structure is important to manage these superstars. Independent Transaction Monitoring: Sumitomo should have created a separate and independent supervisor system within the company hierarchy to avoid these agency issues; specifically the issues between recording and checking procedures. The segregation of duties is really important to prevent these scandals from occurring. In fact, after 1996, many governmental agencies, including ones in Japan, established new rules that provided that the middle and back office should be totally separated from the front office. Corporate Responsibility: We should also consider corporate responsibility with regard to timely reporting. In the Sumitomo case, the management waited ten days until issuing a press release. Even though Sumitomo needed some time to calculate their losses, they could have avoided additional declines in copper prices that were caused because of the rumors and uncertainty in the market.
- #11 LME Regulation: Copper was a thin market at that time in the sense that it could not easily be transferred around the world to meet shortages. The arbitrage opportunity in price differences could be easily offset by additional delivery and storage costs. The challenges in shuffling copper around the world and the fact that even the biggest players hold only 5% of the market made artificial price manipulation possible. Hamanaka’s arrogant strategy was helped greatly by the minimal disclosure obligations, which required no obligation on position reporting and statistics of open interest. Basically, traders knew the price was too high, but they did not have exact figures on how much Hamanaka controlled and how much resources Hamanaka could put from Sumitomo. However, disclosing too much information might cause problems to current market participants. The best way to control the market for LME was to set a temporary rule immediately if the market was going to be crash. Government Regulation: The regulatory agency should execute more stringent rules on the derivatives market to avoid price manipulation and impose new regulations on corporate reporting obligations so as to provide investors and other market participants with greater information regarding the organization’s willingness to take risks and capability to manipulate market prices. The official and market pressures of stringent regulation will strengthen the internal auditing and information systems of many firms and provide a check against possible management discretions.