Case Study: Societe Generale Derivative Losses

Background of the Case:

STOXX limited provides investors with access to markets across Europe, Americas and the Asia-Pacific. The company develops, markets, maintains indices that are markets measures and internationally renowned brands. These indices are investable, tradable and transparent and are marketed to companies across the world to be used as underlying of financial products.

The EURO STOXX index is a list of blue-chip companies of supersector leaders in the Euro Zone. It covers 50 stocks in 12 European countries and is licensed to financial institutions to serve as the underlying for a wide range of investment products like ETFs, F&Os and structured products. The following single country indexes are further derived - EURO STOXX 50 Sub index France, EURO STOXX 50 Sub index Italy and the EURO STOXX 50 Sub index Spain, covering components from France, Italy and Spain respectively.

A trader at Societe Generale bank (Jerome Kerviel) took positions on options on STOXX beyond his trading limits.

Cause of the losses

Initially the market favored him and so he made a lot of profits. With derivatives a small initial investment can give exposure to a large position so Jerome made a lot of profits with a little initial investment, which of course must have fuelled his desire.

The trading limits had been breached and it became a breach of the banks internal policy, which was raised as an issue by the banks risk monitors about 75 times.  However as with most other cases in Derivatives these warnings were ignored by top management as Jerome was making a lot of profits and that was very enticing. The management did not have good knowledge about the subject itself and Jerome himself was asked to draft reply on one occasion.

With the 2008 financial crisis around the corner the trader found it very difficult to make profits after September 2007. Instead of taking losses he started taking more and more positions in the options with the hope that the situation might improve and as a result his net exposure peaked at USD 74 billion. These extra trades were done to make up for the previous losses. Of course nothing lasts forever and the exposure was detected towards the end of the year. The bank decided to wind down the positions immediately and it caused a loss resulting to USD 7 Billion.

The trader was subsequently imprisoned.

This example showcases the most common reason why bank insolvencies happen.