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Risk Takers: Uses and Abuses of Financial Derivatives goes to the heart of the arcane and largely misunderstood world of derivative finance and makes it accessible to everyone-even novice readers. Marthinsen takes us behind the scenes, into the back alleyways of corporate finance and derivative trading, to provide a bird´s-eye view of the most shocking financial disasters of the past quarter century. The book draws on real-life stories to explain how financial derivatives can be used to create or to destroy value. In an approachable, non-technical manner, Marthinsen brings these financial derivatives situations to life, fully exploring the context of each event, evaluating their outcomes, and bridging the gap between theory and practice.

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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

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