How Do You Lose $2 Billion, Part II

News has continued to trickle out regarding the UBS rogue trader in London who lost $2 billion of the bank’s money. But not much news. It has dropped completely off the top stories on my Google news feed. There is plenty of speculation out there, however.

One piece of the story that has been out from the beginning is that the trader in question worked at the “Delta 1 trading desk” in UBS’s London office. This is a standard department in all of the big global investment banks. What these trading desks do is engage in trades for securities that are supposed to move up and down in lockstep. A change (or delta) in one stock of 1%, should be matched by a 1% change in other stocks. Of course, with any actively traded security, the correlation is never perfect, which opens up opportunities to make money.

The Delta 1 desk is supposed to engage in arbitrage, not speculation. Speculation involves swinging for the fences. Bigger risks, but correspondingly bigger rewards. Arbitrage, on the other hand, is about engaging in risk-free transactions that still provide a positive return.

Let’s say you are speculating on the price of wheat. Based on your analysis of global weather patterns, you think the harvest will be bad, and wheat prices will be higher a year from now. You can go into the futures markets and contract to buy (a long position) 10,000 bushels of wheat a year from now, with a price of $1.60 per bushel. A year from now, if you are right, the spot price of wheat goes up to $1.90 per bushel. But your contract says you can buy at $1.60. Your contract is now worth 1.90-1.60, 30 cents a bushel. But there is no guarantee. If the price of wheat actually falls, you can lose money. That’s speculation.

Now change the situation. Imagine that someone will sell you 10,000 bushels of wheat today for $1.50 per bushel. They’ll store it for a year for $200. Your cost of capital to buy the wheat is 5%. You buy the wheat, and then you go into the futures market and contract to sell (a short position) the wheat a year from now at the same $1.60 per bushel. Your costs for wheat, storage, and interest are $15000+200+750, for a total of $15950. A year from now you deliver your wheat and collect $16000. You make a small profit of $50. But by buying and selling simultaneously, you have eliminated any risk. The weather can be good, bad, or indifferent. You are insulated from movements in the spot price. That’s arbitrage.

What Delta 1 traders are supposed to be doing is arbitrage. The net total of your buy positions and the net total of your sell positions are always supposed to be close together. That way your bets are hedged. You can’t make much money on any individual trade, but if something unexpected happens, you won’t lose a lot of money either.

What UBS’s rogue trader was doing was faking one half of the equation. He was placing large speculative bets, and then falsifying the paperwork on the offsetting hedges. Eventually, someone noticed that things weren’t lining up properly, and he was caught.

But $2.3 billion is a lot of misalignment.