What Were They Thinking?

In my spare time I have been reading to take the PRM exams.  There are four exams

• EXAM I: Finance Theory, Financial Instruments and Markets
• EXAM II: Mathematical Foundations of Risk Measurement
• EXAM III: Risk Management Practices
• EXAM IV: Case Studies, PRMIA Standards of Best Practice, Conduct and Ethics, Bylaw

I have been reading for exams III and IV recently.  Part of IV is thirteen case studies of risk management disasters.  From these we are supposed to learn good practices by observing disastrous practices.  Some of the cases (Metallgesellschaft, Barings, LTCM)  are classics of risk.  From Barings we learned we need to separate roles- a trader should not also be in charge of the office. From Metallgesellschaft we learned that futures and forwards are not the same.  From LTCM we learned that liquidity itself has a value. In hindsight it is obvious what mistakes these firms made, however I wonder if the mistakes are obvious to us now only because these spectacular blow-ups highlighted those mistakes and we have learned from them.  Perhaps those risks are obvious in hindsight but they were not obvious in foresight.  However there is one case that just throws me for a loop.  That is the case of China Aviation Oil.

China Aviation Oil (CAO) is a Singapore based company and subsidiary of China National Aviation Fuel Group.  CAO was responsible for hedging airplane fuel (ie jet/kero)  for airports in the PRC.  Initially it just acted as a middle man between the markets and PRC airports- so it bought from the market and sold to PRC airports or visa-verse.  It did not hold significant risk exposure itself.  Eventually it began speculating on the direction of oil and fuel prices using future/swaps/and options...and they were not so good at speculating, as they lost USD 550 MM within a year on their spec positions.  Obviously there was a supervisory problem there.  However one of the reasons that the CAO derivatives disaster was not caught sooner was due to the incredible manner in which they were marking their option positions.

Quick review:  (For option basics see here).

The current value of an option is typically broken into two parts; the INTRINSIC VALUE and the EXTRINSIC VALUE.  The intrinsic value represents how much you would make if you exercised the option right now.  So for a call that would be the current underlying price $S(t)$ minus the strike price$K$, and for a put option that would be the strike price $K$ minus the current underlying price $S(t)$.  The extrinsic value just equals the current option price minus the intrinsic value

• Call:
• Intrinsic Value = $Max(S(t)-K,0)$
• Extrinsic Value =Option Price - Intrinsic Value
• Put:
• Intrinsic Value = $Max(K-S(t),0)$
• Extrinsic Value =Option Price - Intrinsic Value

Extrinsic value is also called time value because it represents the amount of the option value which is NOT due to the amount that one could make by exercising the option today.  The extrinsic value is the amount of the option value that is due to what could happen in the future or over time.

From the definition of Extrinsic Value above you can see that

• Option Price = Intrinsic Value + Extrinsic Value

This is all just Options 101 - the real basics.  However that is not how CAO was valuing their options positions.  At least from an accounting point of view they considered

•  Option Price = Intrinsic Value

So if Crude Oil is currently trading at a price of USD 100 and they sold a call with a strike price of USD 120 then their accounting books would say that option had 0 value.  That is obviously incorrect.  If they were able to sell the option for more than 0 then there must have been a reason - yet CAOs accounting books said the option was worth 0.  That is just crazy wrong.  And the kicker is - this did not occur during the stone-age of derivatives.  This occurred in 2003-2004.

If in the year 2023 I were to be studying for the PRM would I be reading about the risk management disasters of 2013 and saying "what were they thinking"?  I sure hope not.  In the same way that we learned from Barings, and Metallgesellschaft, and LTCM, I hope that we learn from today's disasters - with the caveat that maybe it will be obvious in hindsight but not in foresight.  And then there was China Aviation Oil.  What were they thinking?