Derivatives are often used for hedging, speculation or arbitrage. Investment companies can face some risks when an employee who has a mandate to hedge or to look for arbitrage opportunities may overestimate his capabilities and become a speculator. In 2000 Jerome Kerviel became a member of Societe General (SocGen) and started working in the compliance area. After 5 years he was promoted and became a junior trader in the bank’s Delta One products team. Mostly Kerviel traded equity indices such as the Euro Stoxx 50, German DAX index and French CAC 40. He had to concentrate on search of arbitrage opportunities. Arbitrage often arises if equity index future prices were not consistent with the prices of the shares constituting the index or if a futures contract on an equity index has been trading for different prices on two different exchanges.
Kerviel’s knowledge of the bank’s procedure helped him to create an appearance that he was working with arbitrage opportunities, while most of his work was to speculate. He had large bets in the trend in which the indices would move, and tried to look like he was hedged by creating fictitious trades. At the end of his trader’s career he had tens of millions of Euros of unhedged positions.
Finally in 2008, his speculative trading was revealed. SocGen had loss of more than 4,9 billion Euros from his unauthorized trading. At that time it was the biggest loss created by speculative and fraudulent activity in the history of time.
Looking backwards through the history there have been more fraudulent activities with spectacular losses. In 1990s, Barings Bank had an employee, Nick Leeson, who worked in very similar position as Jerome Kerviel. His job was to look for arbitrage positions at Nikkei 225 futures quotes in Osaka and Singapore. However, he found a way to make huge bets in the direction of the Nikkei 225 using options and futures. His actions caused a loss of more than $1 billion as well as destroyed Barings Bank. In 2002, Allied Irish Bank revealed John Rusnak’s unauthorized foreign exchange trading with a loss of $700 millions. Consequences of such risky unauthorized trading are always very painful and it is very important to define unambiguous limits for traders and then monitor their actions very carefully.