Derivatives as narrated by Frank Partnoy (1999)

I fear I am becoming an armchair critic akin to those analysing every move made by the football (or rugby etc.) manager during their matches.

It is tremendously sad that I am writing about ‘Fiasco: The inside story of a Wall Street trader‘ rather than Charlie D, the ‘legendary’ and almost mythical trader at the Chicago Board of Trade. By way of exclusion and historical reconstruction, he was an honest and compassionate man.

The book’s synopsis caught me eye. Frank’s ‘revelations should stir fear in anyone who owns mutual funds, stock, or even insurance.’ (Again, I reiterate the need for your own research. Instrestingly, you may also find information on the recent global financial meltdown caused by the derivatives like Credit Default Swaps or Collateralised Debt Obligations.)

One topic raised was on PERLS or Principal Exchange Rate Linked Security. Partnoy indicates them as a unique kind of bond (an investment instrument that if held to maturity could return you the invested capital.) In practice, PERLS are ‘structured notes.’ A ‘popular’ PERL repaid the principal based on the changes in 3 currencies – the US dollar; Swiss franc; and British pound. Morgan Stanley sold PERLs as they earned 3.5% more in investment banking fees for them.

Some clients dabble in them because it offers the legal recognition of a bond (protection from legal liability) while offering over the top returns. (First Boston,  another bank sold  the ONE YEAR THAI BAHT BASKET-LINKED NOTE. It promised coupon rates of 11.25%! Now, you compare that with Singapore Government bonds…)  Others, however, bit off more than they could chew. One senior treasury officer from an insurance firm suffered a great shock when $85 million of PERLS fell to ‘a fraction of their original value.’ (He thought the bank was shouldering the exchange rate risk since they were not ‘even allowed to buy foreign exchange.’   These notes/PERLs often had AAA ratings  (since they were issued by government/federal agencies like Freddie Mac or major corporations like General Electric Credit) and complicated formulas.

The shit hit the fan as the Thai baht plunged in 1997 Asian Financial Crisis (AFC). Owners of such structured notes got burned. In one instance, SK Securities (South Korea) lost roughly $300 million to JP Morgan. They wagered that the baht would appreciate relative to the Japanese yen.

On another  note, even investing in specific companies can be extremely costly. Yakult (yes, the one selling drinks to aid your digestion), lost 200 yen per share on 20 March 1998. These were caused by losses from derivative investments; between $500 to 810 million in all. 300 employees were retrenched. Arguably, this was shocker in country known for lifetime employment.

It seems apart from knowledge, caution and awareness, the retail investor is heavily disadvantaged. Legal costs, if one can afford them, are daunting; to boot a winning suit is far from guaranteed. In sum, buyers beware!

[Note: The inspiration for the above are based on Chapters 2,3 and the Postscript of Partnoy’s book.]


Frank Partnoy. Faculty Biography. University of San Diego.

The New York Times. (21 March 1998). INTERNATIONAL BUSINESS; Japan Company Derivatives Loss.

Chester Dawson. (20 March 1998). Japan Co. Has Huge Derivatives Loss. The Associated Press.

Stephen E. Frank. (17 February 1998). J.P. Morgan Sues SK Securities, Seoul Bank in Derivatives Deal. The Wall Street Journal.