How to Lose Money in Derivatives: Examples from Hedge Funds and Bank Trading Departments

What makes futures hedge funds fail? The common ingredient is over betting and not being diversified in some bad scenarios that can lead to disaster. Once troubles arise, it is difficult to take the necessary actions that eliminate the problem. Moreover, many hedge fund operators tend not to make decisions to minimize losses but rather tend to bet more doubling up hoping to exit the problem with a profit. Incentives, including large fees on gains and minimal penalties for losses, push managers into such risky and reckless behavior. We discuss some specific ways losses occur. To illustrate, we discuss the specific cases of Long Term Capital Management, Niederhoffer’s hedge fund, Amaranth and Societe Generale. In some cases, the failures lead to contagion in other hedge funds and financial institutions. We also list other hedge fund and bank trading failures with brief comments on them.

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