21 J. Corp. L. 53 (1995-1996)
Betting the Bank: How Derivatives Trading under Conditions of Uncertainty Can Increase Risks and Erode Returns in Financial Markets

handle is hein.journals/jcorl21 and id is 63 raw text is: Betting the Bank: How Derivatives Trading Under
Conditions of Uncertainty Can Increase Risks and Erode
Returns In Financial Markets
Lynn A. Stout*
I.  INTRODUCTION   ...........................................                   53
II. HEDGING AND ARBITRAGE AS REASONS FOR DERIVATIVES TRADING ....... 55
Ill. SPECULATION AS A REASON FOR DERIVATIVES TRADING .............. 57
IV. THE ROLES OF UNCERTAINTY AND HETEROGENOUS EXPECTATIONS
IN  SPECULATION  ..........     ..............................             59
V. HETEROGENOUS EXPECTATIONS SPECULATION AND TRADER RETURNS                .... 60
VI. HETEROGENOUS EXPECTATIONS SPECULATION AND TRADER RISKS ........ 62
VII. ON THE PERSISTENCE OF HETEROGENOUS EXPECTATIONS SPECULATION              ... 63
VIII. ON THE POSSIBLE SOCIAL BENEFITS OF HETEROGENOUS EXPECTATIONS
SPECULATION IN DERIVATIVES ............................... 64
IX.  CONCLUSION     ............................................                   67
I. INTRODUCTION
On April 12, 1994, Procter & Gamble Co. announced that it had incurred pre-tax
losses of $157 million from trading in leveraged interest rate swaps,' a form of finan-
cial derivative! At the time that figure seemed enormous. Yet within a year, Procter &
Gamble's misfortune had been overshadowed by that of Orange County, a wealthy
California enclave that lost an estimated $2.5 billion of its investment fund as a result
of dealings in reverse-repurchase agreements, inverse floaters, and other arcane instru-
ments.3 Recent months have seen further losses by investment funds, government enti-
* Professor of Law, Georgetown University Law Center; Guest Scholar, The Brookings Institution. The
author would like to thank Martin Mayer and George Martin for their comments, and Luisa Caro, Henry
Smokier, and Myung Yi for their research assistance.
1. Gabriella Stem & Steven Lipin, Procter & Gamble to Take a Charge to Close Out Two Interest-Rate
Swaps, WALL ST. J., Apr. 13, 1994, at A3.
2. This Article assumes that the reader has a basic working knowledge of derivatives and their various
forms and uses. For those unfamiliar with these instruments, see generally U.S. GENERAL ACCOUNTING OF-
FICE, FINANCIAL DERIVATIVES: ACTIONS NEEDED TO PROTECT THE FINANCIAL SYSTEM (1994) [hereinafter
GAO REPORT]; FEDERAL RESERVE BANK OF ATLANTA, FINANCIAL DERIVATIVES: NEW INSTRUMENTS AND
THEIR USES (1993) [hereinafter FEDERAL RESERVE REPORT]; Saul S. Cohen, The Challenge of Derivatives, 63
FORDHAM L. REVIEW 1993 (1995); Henry T.C. Hu, Misunderstood Derivatives: The Causes of Informational
Failure and the Promise of Regulatory Incrementalism, 102 YALE L.J. 1457 (1993). Although the word de-
rivative is used to describe an increasingly broad array of financial arrangements, this Article uses the word
primarily to refer to various options, futures, and forwards. See generally Henry T.C. Hu, Hedging Expecta-
tions: Derivative Reality and the Law and Finance of the Corporate Objective, 73 TEX. L. REV. 985, 996-
1000 (1995), reprinted in 21 J. CORP. L. 3 (1995) (discussing meaning of derivative).
3. Laura Jerenski, Orange County Fund Losses Put at $2.5 Billion, WALL ST. J., Dec. 12, 1994, at A3.

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