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How to Lose Money in Derivatives: Examples from Hedge Funds and Bank Trading Departments

In: THE WORLD SCIENTIFIC HANDBOOK OF FUTURES MARKETS

Author

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  • Sebastien Lleo
  • William T. Ziemba

Abstract

What makes futures hedge funds fail? The common ingredient is over betting and not being diversified in some bad scenarios that can lead to disaster. Once troubles arise, it is difficult to take the necessary actions that eliminate the problem. Moreover, many hedge fund operators tend not to make decisions to minimize losses but rather tend to bet more doubling up hoping to exit the problem with a profit. Incentives, including large fees on gains and minimal penalties for losses, push managers into such risky and reckless behavior. We discuss some specific ways losses occur. To illustrate, we discuss the specific cases of Long Term Capital Management, Niederhoffer's hedge fund, Amaranth and Société Générale. In some cases, the failures lead to contagion in other hedge funds and financial institutions. We also list other hedge fund and bank trading failures with brief comments on them.

Suggested Citation

  • Sebastien Lleo & William T. Ziemba, 2015. "How to Lose Money in Derivatives: Examples from Hedge Funds and Bank Trading Departments," World Scientific Book Chapters, in: Anastasios G Malliaris & William T Ziemba (ed.), THE WORLD SCIENTIFIC HANDBOOK OF FUTURES MARKETS, chapter 22, pages 689-750, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789814566926_0022
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    References listed on IDEAS

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    1. Franklin R. Edward, 1999. "Hedge Funds and the Collapse of Long-Term Capital Management," Journal of Economic Perspectives, American Economic Association, vol. 13(2), pages 189-210, Spring.
    2. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    3. Franklin R. Edwards & Michael S. Canter, 1995. "The Collapse Of Metallgesellschaft: Unhedgeable Risks, Poor Hedging Strategy, Or Just Bad Luck?," Journal of Applied Corporate Finance, Morgan Stanley, vol. 8(1), pages 86-105, March.
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    Cited by:

    1. Lleo, Sébastien & Ziemba, William T., 2015. "Some historical perspectives on the Bond-Stock Earnings Yield Model for crash prediction around the world," International Journal of Forecasting, Elsevier, vol. 31(2), pages 399-425.
    2. Westgaard, Sjur & Frydenberg, Stein & Mohanty, Sunil K., 2022. "Fourteen large commodity trading disasters: What happened and what can we learn?," Journal of Commodity Markets, Elsevier, vol. 27(C).

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    More about this item

    Keywords

    Futures Markets; Pricing; Risk Management; Futures Trading; Stock Indexes; Interest Rates; Futures Prices; Portfolio Theory; Hedge Funds; Foreign Exchange;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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