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Chapter 2 Roche Holding: the Company, Its Risk Takers Uses and Abuses of Financial Derivatives John E. Marthinsen Babson College PEARSON Addison Wesley Boston San Francisco New York London Toronto Sydney Tokyo Singapore Madrid Mexico City Munich Paris Cape Town Hong Kong Montreal Preface xiii Parti 1 Chapter 1 Employee Stock Options: What Every MBA Should Know 3 Introduction 3 Employee Stock Options: A Major Pillar of Executive Compensation 6 Why Do Companies Use Employee Stock Options 6 Aligning Incentives 7 Hiring and Retention 7 Postponing the Timing of Expenses 8 Adjusting Compensation to Employee Risk Tolerance Levels 8 Tax Advantages for Employees 9 Tax Advantages for Companies 9 Cash Flow Advantages for Companies 10 Option Valuation Differences and Human Resource Management 12 Problems with Employee Stock Options 26 Employee Motivation 26 The Share Price of "Good" Companies 27 Motivation of Undesired Behavior 28 vi Contents Performance Improvement 28 Absolute Versus Relative Performance 29 Some Innovative Solutions to Employee Stock Option Problems 29 Premium-Priced Stock Options 30 Index Options 30 Restricted Shares 34 Omnibus Plans 34 Conclusion 35 Review Questions 36 Bibliography 38 Chapter 2 Roche Holding: The Company, Its Financial Strategy, and Bull Spread Warrants 41 Introduction 41 Roche Holding AG: Transition from a Lender to a Borrower 43 Loss of the Valium Patent in the United States 43 Rapid Increase in R&D Costs, Market Growth, and Industry Consolidation 43 Roche's Unique Capital Structure 44 Roche Brings in a New Leader and Replaces Its Management Committee 46 A New Financial Strategy 46 Roche's 1991 Bull Spread Issue 49 Why Did Roche Choose Long-Term, Dollar-Denominated Debt? 49 Details of the Bull Spread Issue 50 CONTENT HIGHLIGHT 2.1: What Are the Differences Between Warrants and Options? 51 Target Investor Group 52 Analysis of the Bull Spread's Return to Investors 53 CONTENT HIGHLIGHT 2.2: Calculation of the Weighted Average Return on Roche's Bond Cum Warrants 62 Analyzing the Bull Spread Issue from Roche's Side 65 Roche's Bull Spread Issue: The Result 69 Conclusion 70 Contents vii Review Questions 72 Further Reading 74 Bibliography 74 Chapter 3 The Three Amigos 75 Introduction: The Three Amigos and Their Strategy 75 Developing and Implementing a Speculation Strategy: A Conversation 78 A Deeper Look at the Three Amigos' Strategy 87 Why Getty's Share Price Would Not Fall 88 Why Getty's Share Price Had Not Already Increased 88 Step by Step: The Three Amigos' Speculation Strategy 91 Put-Call Parity 94 Another Look at the Three Amigos' Speculative Strategy 95 Does the Price of an Option Always Reflect Its Expected Value? 96 What Happened to the Three Amigos' Trade 97 Conclusion 98 Review Questions 99 Bibliography 100 Part II 101 Chapter 4 Metallgesellschaft AG: Illusion of Profits and Losses, Reality of Cash Flows 103 Introduction 103 Metallgesellschaft: Evolution of the Company and Its Product Lines 104 Energy Derivatives at MGRM 105 Energy Markets on a Roller-Coaster Ride 105 MGRM's Innovative Energy Derivative Products 106 CONTENT HIGHLIGHT 4.1: What Are the Differences Between Forward Markets and Futures Markets? 108 viii Contents Understanding How MGRM Hedged Its Forward Exposures 109 The Stack-and-Roll Hedge 111 What Went Wrong at MGRM? 114 CONTENT HIGHLIGHT 4.2: What Is the Difference Between Contango and Backwardation? 116 Oil Prices Fall, Markets Move to Contango, and MGRM's Large Positions Create Problems 117 MGRM Butts Heads with the Commodity Futures Trading C ommission 119 MGRM's Profitability: It's All in How You Account for It 119 MGRM's Credit Rating 120 The Effects of an Itchy Trigger Finger 120 Was MGRM Hedging or Speculating? 121 Corporate Governance Issues 122 Conclusions 123 Review Questions 124 Epilogue: What Happened to the Key Players in the MGAG Disaster? 126 Further Reading 126 Bibliography 127 Chapter 5: Swaps That Shook an Industry: Procter & Gamble versus Bankers Trust 128 Introduction 128 P&G's Motivation for the Swaps 130 Motives for the U.S. Dollar-Denominated Interest Rate Swap 131 Motives for the German Mark-Denominated Interest Rate Swap 131 CONTENT HIGHLIGHT 5.1: What Is an Interest Rate Swap? 132 Motives for Using the Over-the-Counter Market 134 The U.S. Dollar-Denominated Swap 135 Plain Vanilla Swap 135 P&G's Gamble: The Speculative Side-Bet 136 Contents ix German Mark-Denominated Interest Rate Swap 143 The Suit Against Bankers' Trust 145 CONTENT HIGHLIGHT 5.2: Value at Risk 146 The P&G-BT Settlement 147 How Did BT Fare After the Swaps? 147 P&G-BT from an Investor's Perspective 148 The Landmark P&G-BT Court Opinion 149 Major Legal Issues 149 An Unusual Court Opinion 150 Summary of the Court Opinion 150 Disclosure Reform After P&G-BT 151 Should Corporate Treasuries Be Profit Centers? 152 Conclusions 152 Review Questions 153 Epilogue: What Happened to the Players in P&G-BT? 154 Further Reading 156 Bibliography 156 Chapter 6: Orange County: The Largest Municipal Failure in U.S. History 158 Introduction 158 Robert Citron and the Orange County Board of Supervisors 159 The Orange County Investment Pool 162 The Major Risks Facing Assets in the OCIP Portfolio 165 Credit Risk 165 Market Risk 165 Liquidity Risk 166 OCIP's Assets and Funding Sources 167 Structured Notes 168 Fixed-Income Securities 169 OCIP's Funding Sources 169 Contents CONTENT HIGHLIGHT 6.1: Other Assets in the OCIP Portfolio 170 Leveraging the OCIP Portfolio 173 Effects of Leverage on OCIP's Return 175 OCIP's Rising Returns: Effects of Falling Interest Rates 175 OCIP's Return Stabilizes: 1993 177 OCIP's Returns Plummet: 1994—Effects of Rising Interest Rates 177 The Consequences 179 Market Risk Causes Liquidity Risk 180 Government Paralysis 181 Citron Resigns 181 Lack of Liquidity Leads to Bankruptcy 181 Fire Sale of the OCIP Portfolio 182 Monday-Morning Quarterbacking 182 Was Orange County Truly a Derivative-Related Failure? 182 Was Orange County Really Bankrupt? 184 Was It a Mistake to Liquidate the OCIP Portfolio? 185 Could the Debacle Have Been Predicted? 186 Sentences, Blame, and Reform 187 Robert Citron 187 Shared Blame 188 Governance Reforms 189 Lessons Learned from Orange County 190 Safety, Liquidity, and High Yield Are an Impossible Combination 190 If You Can't Explain It, Then Don't Do It 190 Conclusion 191 Review Questions 192 Further Reading 192 Bibliography 192 Chapter 7: Barings Bank PLC: Leeson's Lessons 194 Introduction 194 Nick Leeson 195 CONTENT HIGHLIGHT 7.1: What Is Margin? 198 Contents xi Leeson's Trading Strategy 200 Doubling Strategy 201 CONTENT HIGHLIGHT 7.2: Marking-to-Market 204 Fictitious Trades, Falsified Records, and Option Sales to Raise Funds 206 Leeson's Trading Position: The Net Profit-and-Loss Profile of His Exposures 206 Leeson's Sales of Short Straddles 206 Combining a Short Straddle and a Long Futures Contract 208 Combining a Long Futures Position and Numerous Short Puts 209 Leeson Accumulates Losses 210 Blame Beyond Leeson: Management Control of Trading Operations 212 A Bank for a Pound 214 Aftermath of the Barings Failure 214 Conclusions: Leeson's Lessons 215 Review Questions 216 Bibliography 217 Chapter 8: Long-Term M/smanagement: " JM and the Arb Boys" 218 Introduction 218 Content Highlight 8.1: What Is a Hedge Fund? 220 LTCM: The Company 221 The LTCM Business 221 The Partners 221 LTCM's Strategy 223 Identifying Small Market Imperfections 224 Using a Minimum of Equity Capital 229 Securing Long-Term Funding 232 Charging Hefty Fees 234 LTCM's Impressive Performance: 1994-1997 234 LTCM's Contributions to Efficient Markets 237 xii Contents Why and How LTCM Failed 237 Yield Spreads Widen Globally 238 CONTENT HIGHLIGHT 8.2: What Is Contagion? 240 Liquidation of Salomon Brothers' U.S. Bond Arbitrage Group 240 Volatile Political and Economic Climate 241 Value at Risk Analysis Gone Awry 241 Liquidity Dries Up 244 The Fed, Warren Buffett, and the Rescue of LTCM 244 Conclusions and Lessons to Be Learned 248 Be Careful What You Wish For 248 Stress Test Your Assumptions 248 Leverage Is a Fair-Weather Friend 249 Financial Transparency Is the First Step in Meaningful Reform 249 In the Long Run, Bet on Global Financial Markets Being Efficient 249 You Can't Float Without Liquidity 250 A Final Word 250 Review Questions 250 Epilogue: What Happened to the Partners, Creditors, Investors, and the Consortium? 251 The Partners 251 Creditors and Investors 252 The Consortium 253 Further Reading 253 Bibliography 253 Appendix 8.1: LTCM's Major Trades 255 Spread Trades 255 Relative-Value Trades 255 Convergence Trades 257 Directional Trades 258 Outright Equity Purchases 258 Risk Arbitrage 258 Buying and Selling Volatility 259 Index 261.
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