SocGen rouge trader: How did he do it?

It's because he was a red trader; he had Stalin, Lenin, and Castro all helping him out.

Remember, you will always be a salesman, no matter how fancy your title is. - My ex girlfriend

I am more interested in the technicality than in the conspiracy theory...

Sorry! I am not in my funny mood today...

Disjoint, for what it's worth, I thought it was pretty funny...

"It is a fine thing to be out on the hills alone. A man can hardly be a beast or a fool alone on a great mountain." - Francis Kilvert (1840-1879)

"Ce serait bien plus beau si je pouvais le dire à quelqu'un." - Samivel

AAchimp good commentary but i believe what the OP is asking is what he failed to hedge.

Jerome Kerviel job was on SocGen's delta one desk. In particular he was an index arbitrage trader. For you to understand how this incident happened you must first understand index arbitrage as a strategy.

Index arbitrage is a strategy that involves trading the spread between stock index futures and the underlying cash index itself. Stock index futures naturally trade at a discount to the underlying cash market. This discount or spread in effect is what Jerome Kerviel's job to arbitrage. An arbitrageurs job is to ensure that inter market relationships hold steady. If the spread becomes too wide what the arbitrageur will do is take the trade that will benefit when the spread converges to its correct theoretical value.

In order to achieve good returns the use of leverage or very large positions is used to compensate for low absolute terms. This is essentially the same strategy that LTCM was using. Its a mean reversion play. Since Kerviel was long 1mm FESX (DJ Euro Stoxx 50 futures) he would in turn be required to short the same amount of the underlying stocks with the appropriate weight of each stock. Since he failed to enter the short position as a hedge he was in effect left with a directional 1mm contract Eurostoxx position.

To help clarify this more I will post an example.
On friday the Dow closed at 12609.42 and the Dow emini (YM) closed at 12610, essentially they should be trading at very comparable levels. Suppose during the session the Futures were trading at 12550 and the dow cash index was trading at 12575, what an arbitrageur would do would be to buy the Futures and sell the equivalent amount of the individual components. In this case the spread has expanded from its theoretical fair value of 0 to 25. An arbitrageur would buy 100 YM futures and sell the equiavent underlying.

But what happens when you dont sell the underlying? If you fail to sell the equivalent underlying you are essentially doing what Jerome Kerviel did, in this case you would be net long 100 contracts with a position delta of 5X 100 = $500 meaning for every point the dow futures increase you gain $500 and for every point they decrease you lose $500. Referencing our example the spread is 25 X 500 = 12,500. What we know is that this spread SHOULD converge, when it does the arbitrageur profits, when it expands the arbitrageur loses. But when like Jerome Kerviel does not hedge there is no protection and you are left with an outright bet on the futures market with no hedge to limit your risk.

Index arbitrage is a strategy with SUBSTANTIALLY less risk than placing directional bets in the futures market. Because it is less risky large quantities are traded to make up for this lack in absolute gains. The only time this strategy is not risky is when you have put on the hedge. When you are unhedged this becomes nothing but a direction bet on the market.

I hope this helps. Please feel free to ask any questions.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

Thank you for the great comment! Exacrtly what I was looking for!!!

I am digesting it...:-) But will be back with Qs.

Thanx again!!!

someone called LTCM's strategy like "picking up nickels off the ground" In effect they were chasing the slimest of margins. Someone else then pointed out what they were doing was "picking up nickels in front of bulldozers.

My analogy of what Jerome Kerviel did. If index arbitrage is like walking across the street at a red light to pick up a dollar, then what Jerome Kerviel was doing was running across the an 8 lane highway blindfolded with a bomb strapped to himself to pick up a million dollars. Sure the prize on the other side can be huge but the risks of when you lose are catastrophic.

The bottom line is index arbitrage can be very boring because your chasing very small returns with very little risk. My analogy shows you that it can be a very dangerous game, such as running across a highway blindfolded with a bomb strapped to your back.

Hope this helps.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"