- Email: [email protected]
The Amsterdam options exchange in 1998:
Pergamon
PII:
European Management Journal Vol. 19, No. 3, pp. 286–290, 2001 2001 Elsevier Science Ltd. All rights reserved Printed in Great Britain S0263-2373(01)00025-1 0263-2373/01 $20.00 + 0.00
The Amsterdam Options Exchange in 1998: How the Supervisory Authorities Turned a Problem Into a Crisis ANDRE´ DORSMAN, Nyenrode University and the Free University, Amsterdam ADRIAN BUCKLEY, Cranfield School of Management and the Free University, Amsterdam In the great share price setbacks of 1987 and 1998, financial authorities, in The Netherlands, as elsewhere in the world, adopted policies to stabilise financial markets. The Dutch response was effective in the former case but, in the latter instance, the actions of authorities magnified problems, especially for equity options markets. Our analysis suggests that regulatory authorities pursued a course which corrected for turbulence when financial problems first occurred in 1998 but failed to monitor and restabilise. When a second setback in equity markets impacted later in the year, the original stabilising policy magnified problems rather than calming them. 2001 Elsevier Science Ltd. All rights reserved. Keywords: Financial crisis, Equity options, Regulatory authorities, Stabilisation policy, Monitoring
York: the worst day in October 1998 exhibited a 7.2 per cent setback in the DJIA — see Table 1. In 1987, central banks around the world, including the Dutch central bank, came to the aid of struggling financial markets with an infusion of liquidity. This intervention was speedy and contained the turmoil quickly. In 1998, however, the story was different. Equity prices declined less rapidly than in 1987 and monetary authorities did not rush in with intervention. That is not to say that there was no intervention at all — it was merely less intense and, generally, more subtle. This was the case for most national financial markets — it was certainly so in The Netherlands. This paper summarises how the financial crises in the options market in Holland in 1998 was handled and how rather benign intervention designed to ward off problems in early 1998 came home to roost by causing a magnified crisis later in the year. As is so often the case, good intentions, unless monitored as to their effects, can easily backfire to create unforeseen further problems.
Introduction In The Netherlands, as in other parts of the western world, stock prices have risen steadily and sharply since 1982 — see Figure 1. The solid rise has been punctuated by two sharp declines — in 1987 and 1998. The former slide was far more precipitous than the latter. Indeed, in percentage points decline, 19 October 1987 witnessed a staggering 22.6 per cent fall in the Dow Jones Industrial Average (DJIA) in New 286
It all happened in the Amsterdam options markets. In 1987, the options exchange was relatively small compared to the equity market: in 1998, it had grown substantially in importance and size. The decline of equity prices, in 1998, had a very significant effect upon the options exchange — but not in the way that one would have anticipated. The mode of intervention might have increased financial problems. We look at how this happened and we try to draw some European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
THE AMSTERDAM OPTIONS EXCHANGE IN 1998
Figure 1 An Index of Dutch Equities (Based on the Herbeleggingsindex with 1 January 1973 set at 100) Assuming Dividend Reinvestment
Table 1 The Dow Jones Industrial Index — The Ten Largest Day Declines Ever on Absolute Basis and Percentage Basis Days with the largest decrease in points Date Points % 1 2 3 4 5 6 7 8 9 10
27-10-1997 31-08-1998 19-10-1987 27-08-1998 04-08-1998 10-09-1998 15-08-1997 30-09-1998 14-01-1999 09-01-1998
554.26 512.61 508.00 357.36 299.43 249.48 247.37 237.90 228.63 222.20
7.19 6.37 22.61 4.19 3.40 3.17 3.11 2.94 2.45 2.85
Days with the largest percentage decrease Date Points % 19-10-1987 28-10-1929 29-10-1929 06-11-1929 18-12-1899 12-08-1932 14-03-1907 26-10-1987 21-07-1933 18-10-1937
508.00 38.38 30.57 25.55 5.57 5.79 6.89 156.83 7.55 10.57
22.61 12.82 11.73 9.92 8.72 8.40 8.29 8.04 7.84 7.75
Source: Financieele Dagblad 5 June 1999. Permission to reprint granted
conclusions. But, first of all, it is necessary, briefly, to summarise some aspects of the options market.
Options Markets An options contract gives the holder of it the right, but not the obligation, to buy or sell securities or commodities at a specified price — the exercise price (also called the strike price) — on, or before, a given date (the expiration date or maturity date). Note that an option gives a right — but not an obligation. Options to purchase securities are termed calls; options to sell are known as puts. The individual issuing an option is called the seller. The original issuer of an option at the very beginning of its life is called the option writer. Having bought an option from the original writer, the purchaser may, later, decide to sell on the option to another purchaser so that the option may be sold on once, twice, thrice or many more times, rather like shares sold on in the European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
stock market. The individual purchasing an option is called the buyer. On the Amsterdam Options Exchange, as in other options markets, banks, financial institutions and high net worth individuals act as options writers. In return for being the original seller of new options contracts, they receive a fee from the purchaser — this fee is called the option premium. If the purchaser subsequently sells on the option contract to a third party, he or she, too, receives a premium from such a sale. Hopefully, the fee that he or she receives exceeds that previously paid to the option writer. Original options writers are market makers, holding themselves open to quote prices on a range of options contracts. In our story, the options that were at the centre of the turmoil were options on the level of the Dutch stock market (the AEX). Option pricing is a subject of more than moderate complexity. The good news is that there is a math287
THE AMSTERDAM OPTIONS EXCHANGE IN 1998
ematical model — the Black and Scholes model, for the development of which a Nobel prize in economics was awarded — that explains the level of the option premium. And the very good news is that, in this paper, we are not going to focus upon the math underpinning it. Suffice to say that there are five drivers of option premium value in respect of a nondividend paying stock and these are: ❖ the share price of the stock (called the underlying asset) upon which an option is written. In the case in point here, the underlying asset was the Dutch stock market index ❖ the exercise price of the option ❖ the time to maturity of the option ❖ the volatility (a measurement of the expected extent of upward and downward movements) of the underlying asset in the period to maturity ❖ interest rates until maturity of the option How movements in these five value drivers affect the option premium are summarised in Table 2. Note, from the table, that three of these value drivers have an opposite effect for the call option vis-a`-vis the put option. This is not the case with volatility and time-to-maturity. A lessening of the time-to-maturity reduces the value of both the put as well as the call option. The same effect is true for volatility. Turmoil in financial markets translates into higher volatility for the underlying asset and, therefore, results in an increase in the value of both put options and call options. As of early 1998, following the long upward rise from the early eighties, (with the exception of the hiccup in October 1987) — see Figure 1 — equity markets could be described as being quite bullish. Investors were still substantial net buyers of shares. To limit their downside risk, they were also increasingly buying put options on these underlying assets. What does this mean? And how does it work? Investors with portfolios of ordinary shares might not want to liquidate their investments merely because they perceive that downside risk is increasingly Table 2 Value Driver Movements and Option Premium Effects The variables
Rise in variable Influence on a call option
Share price (underlying asset) Exercise price Time-to-maturity Volatility of share price Interest rate
288
Influence on a put option
Increases
Decreases
Decreases Increases Increases
Increases Increases Increases
Increases
Decreases
apparent. Indeed, this might be particularly so if the equity market continues its upward momentum. But the portfolio might be hedged without unloading any shares — and this might be achieved by dealing options. Imagine that the ordinary share index is at 650. By buying a put option on the index at 650, the possession of such an option gives the purchaser the right (but not the obligation) to sell out at 650. Imagine further that, when purchased, the option has six months to run to maturity. This gives the purchaser protection against adverse stock movements for six months — or for a shorter period if the holder sells on the option. If, just after three months were up, the market level had fallen to 600, the option holder might sell his option at a profit of 50 points (650 minus 600). Of course, remember that the option purchaser held a portfolio of equity shares. Their prices will, most likely, have fallen — so the unrealised loss on the equity portfolio would be offset (not exactly but, hopefully, approximately) by a realised gain by selling on the option on the stock market index. Of course, had equity shares risen during the three month period in which the put option purchaser held the option, he or she would simply not have sold on the option but would happily have sat on the gain in equity shares.1 Buying put options limits downside risk (at the cost of the option fee, or premium) but keeps open upside potential. So, in early 1998, investors who felt that share prices would rise, but also saw significant downside potential, bought put options to protect their portfolios. Of course, investors, convinced of further rises, without excessive downside, might simply have bought call options — or, indeed, equities in general. In early 1998, activity in the Amsterdam equity option market was pronounced. Market makers were obliged to write put and call options as counterparties for investors seeking portfolio insurance. Besides this, 1996 and 1997 had witnessed the successful introduction of several large ‘click-funds’ (click-fondsen). These click funds are investment funds that invest in certain stock indices. At the same time, these funds also guarantee that should the index rise by a certain percentage then the capital gains will be clicked — or frozen — at that higher level. This strategy seemed attractive to risk-averse investors. It means, in fact, that with the purchase of a share in the click-fund, one actually invests in an index (representing the level of the stock market) and buys a put option on that index at the same time — a put option with an exercise price which is higher than the initial price. The managers of the click fund will wish to transfer the fund’s risk to the market makers — so it deals options on the index, in the manner suggested. Market makers, who are, of course, option writers, European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
THE AMSTERDAM OPTIONS EXCHANGE IN 1998
settle their transactions through so-called clearing members of the options exchange. Clearing members guarantee the credit worthiness of option writers. As part of this process of ensuring that option writers deliver in accordance with their obligations, the option writers have to deposit funds — called margin — based on a percentage of the market value of open options contracts. Note that the market value of put options will increase if the stock market levels fall. Clearing members are often subsidiaries of banks. A clearing member supervises the position of a market maker. The financial strength of clearing members should ensure that options contracts are honoured. The summer of 1998 witnessed a turn of events — a decline in stock prices. Although the fall in 1998 was nowhere so precipitous nor so extensive as in 1987, there was a series of multiple shocks extending over a longish period of time and pushing financial markets into turmoil during this period. And, in August of 1998, volatility of stock prices rose sharply — see Figure 2 — which, in turn, caused option prices to rise. This had an adverse impact on option market makers’ cash flow positions. They were forced, by the rules of the Amsterdam exchange, to pay in more funds to meet the margin requirements discussed earlier. Furthermore, the fact that the stock price index was falling meant that all of those put option contracts, taken out by investors to protect portfolio positions, were gaining in value and, consequently, resulted in more margin calls for option writers. They were facing a double whammy of margin calls. This created problems.
The Policy Approach by the Dutch Financial Authorities Given that the options exchange was much smaller in 1987 compared to 1998, the margin problems that
manifested themselves latterly were not there in 1987. The sharp decline in share prices on a worldwide scale in October 1987 led financial authorities everywhere to respond rapidly and, almost, in unison with a similar strategy — central banks (including the Dutch Central bank) infused muchneeded liquidity. Many small- to medium-sized banks around the world owe their survival to this intervention, which contained the possibility of a domino effect crisis in the banking sector. The turmoil in 1987 financial markets is dramatically tabulated in Figure 2 which shows daily standard deviations (volatility) of stock prices. The figure also shows that the 1998 turmoil was less pronounced but more prolonged. This latter point is relevant in the rest of our story. Early in 1998 — before the October crisis — Dutch supervisory and regulatory authorities were worried about the effects that increased option activity and heightened volatility (see Figure 2) might have. They were concerned to protect purchasers of options against the possible inability of option writers to meet their obligations. They did this by requiring option writers (market makers) to increase their threshold of position and credit requirements. Effectively, this meant that they would have to put up a greater percentage as margin — even on open contracts already entered into. The objective was to reduce chances of default by market makers. This action was taken early in 1998 and, because the share price decline was a slow and gradual one, the problem for market makers was, initially, containable. Table 1 shows that there were many days in the summer of 1998 which showed big drops in share prices in absolute terms, although none compared, in percentage terms, with Black Monday, 19 October 1987. However, as declines mounted in September 1998, difficulties multiplied. Remember, as markets fall, put option values rise — and, in the Amsterdam options market, so did margin calls based on a per-
Figure 2 The Standard Deviation of Dutch Equities (Based on the Herbeleggingsindex — see Figure 1)
European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
289
THE AMSTERDAM OPTIONS EXCHANGE IN 1998
centage of the value of open option contracts. Furthermore, these margin requirements were magnified under the new rules. Severe liquidity problems arose. Positions that were easily maintainable earlier in 1998, now became precarious. In the first week of September 1998, a subsidiary of ING (The Netherlands’ second largest bank), called Extra Clearing, was facing extreme financial difficulties. This clearing institution was confronted with two market makers that were not able to meet their margin requirements. Extra Clearing could do two things. Either, it could liquidate the positions of the market makers concerned. Since these market makers were net writers of put options on the level of the stock market, this would crystallise losses and, possibly, lead to financial difficulties for other market makers — in a domino effect scenario. Or, a second possibility would be for Extra Clearing to extend more credit to the market makers concerned. Extra Clearing chose the second course of action. But, a continued decline in equity prices made this extension of credit activities get further out of hand. ING, itself, was forced to intervene, at great cost. The losses that were made public were estimated at up to NLG 75 million — that is, almost USD 40 million. Was this just the tip of the iceberg? Probably, as subsequently indicated by figures in the published accounts. The capital base of Extra Clearing was replenished and the exposures of several market makers were taken on by ING itself. The option positions, which were mostly in AKZO Nobel (one of Holland’s top ten stocks) and de Arnhemse (an investment company with large holdings in AKZO Nobel), were, in part, liquidated. This, in turn, affected the share price of AKZO Nobel. And, in 1999, ING decided to put in a bid for de Arnhemse — probably all driven by the options market crisis and its handling by Dutch supervisory and regulatory authorities.
Conclusions The ‘solution’ promulgated by the authorities to deal with the problem in the options market in 1998 actually increased financial turmoil, rather than calming it down. Unfortunately, the authorities did not react in the same manner as the Dutch Central Bank had in 1987. Of course, the Dutch Central Bank is detailed, amongst other things, to serve the public interest. Clearing members of the options exchange only serve the interest of their clients — that is, the market makers. Based on the evidence that we have seen and summarised here, we would seriously question whether regulatory and supervisory authorities in The Netherlands were sufficiently on the ball in 1998. Certainly, having initially come up with a ‘solution’, continued monitoring of developments through the summer and, particularly, into the autumn of 1998 should have made it clear that adjustments to the prescribed policy were necessary — and they were needed quickly. But, nothing happened. We had a new stimulus — but no response from the authorities. Financial regulators need to remember that it is occasionally necessary to take preventative and corrective action — but it is necessary, then, continually to monitor the consequences of such action and to change it, if necessary. The moral of this particular tale is equally applicable to other parts of our geographical and social world and to other, similar, bail-out situations. And, of course, it is really what control system mechanisms are all about. We forget this at our peril.
Note 1. Cognoscenti of options will know that, in reality, the option might have been sold on for time value.
ANDRE´ DORSMAN, University of Nyenrode, Straatweg 25, 3621 BG Breukelen, The Netherlands. E-mail: a.dorsman@nyenro de.nl
ADRIAN BUCKLEY, Cranfield School of Management, Cranfield University, Bedford, MK43 0AL. Email: adrian.buckley@ cranfield.ac.uk
Dr Andre´ Dorsman is Professor of Finance and Investment Analysis at the University of Nyenrode and linked to the Free University, Amsterdam. His teaching focuses on investment analysis, performance measurement and financial instruments. He has written two Dutch textbooks: Vlottend Financieel Management and Vermogensstructuur en Vermogensmarkt (Kluwer, 1999). A recent book, Gestion Financie`re, was published for the Belgian market (Standaard, 2001).
Dr Adrian Buckley is Professor at Cranfield School of Management and Visiting Professor at the Free University, Amsterdam. His teaching and research interests include international finance and real operating options. He is author of a number of finance textbooks, of which Multinational Finance, now in its fourth edition, is the most wellknown.
290
European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
PII:
European Management Journal Vol. 19, No. 3, pp. 286–290, 2001 2001 Elsevier Science Ltd. All rights reserved Printed in Great Britain S0263-2373(01)00025-1 0263-2373/01 $20.00 + 0.00
The Amsterdam Options Exchange in 1998: How the Supervisory Authorities Turned a Problem Into a Crisis ANDRE´ DORSMAN, Nyenrode University and the Free University, Amsterdam ADRIAN BUCKLEY, Cranfield School of Management and the Free University, Amsterdam In the great share price setbacks of 1987 and 1998, financial authorities, in The Netherlands, as elsewhere in the world, adopted policies to stabilise financial markets. The Dutch response was effective in the former case but, in the latter instance, the actions of authorities magnified problems, especially for equity options markets. Our analysis suggests that regulatory authorities pursued a course which corrected for turbulence when financial problems first occurred in 1998 but failed to monitor and restabilise. When a second setback in equity markets impacted later in the year, the original stabilising policy magnified problems rather than calming them. 2001 Elsevier Science Ltd. All rights reserved. Keywords: Financial crisis, Equity options, Regulatory authorities, Stabilisation policy, Monitoring
York: the worst day in October 1998 exhibited a 7.2 per cent setback in the DJIA — see Table 1. In 1987, central banks around the world, including the Dutch central bank, came to the aid of struggling financial markets with an infusion of liquidity. This intervention was speedy and contained the turmoil quickly. In 1998, however, the story was different. Equity prices declined less rapidly than in 1987 and monetary authorities did not rush in with intervention. That is not to say that there was no intervention at all — it was merely less intense and, generally, more subtle. This was the case for most national financial markets — it was certainly so in The Netherlands. This paper summarises how the financial crises in the options market in Holland in 1998 was handled and how rather benign intervention designed to ward off problems in early 1998 came home to roost by causing a magnified crisis later in the year. As is so often the case, good intentions, unless monitored as to their effects, can easily backfire to create unforeseen further problems.
Introduction In The Netherlands, as in other parts of the western world, stock prices have risen steadily and sharply since 1982 — see Figure 1. The solid rise has been punctuated by two sharp declines — in 1987 and 1998. The former slide was far more precipitous than the latter. Indeed, in percentage points decline, 19 October 1987 witnessed a staggering 22.6 per cent fall in the Dow Jones Industrial Average (DJIA) in New 286
It all happened in the Amsterdam options markets. In 1987, the options exchange was relatively small compared to the equity market: in 1998, it had grown substantially in importance and size. The decline of equity prices, in 1998, had a very significant effect upon the options exchange — but not in the way that one would have anticipated. The mode of intervention might have increased financial problems. We look at how this happened and we try to draw some European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
THE AMSTERDAM OPTIONS EXCHANGE IN 1998
Figure 1 An Index of Dutch Equities (Based on the Herbeleggingsindex with 1 January 1973 set at 100) Assuming Dividend Reinvestment
Table 1 The Dow Jones Industrial Index — The Ten Largest Day Declines Ever on Absolute Basis and Percentage Basis Days with the largest decrease in points Date Points % 1 2 3 4 5 6 7 8 9 10
27-10-1997 31-08-1998 19-10-1987 27-08-1998 04-08-1998 10-09-1998 15-08-1997 30-09-1998 14-01-1999 09-01-1998
554.26 512.61 508.00 357.36 299.43 249.48 247.37 237.90 228.63 222.20
7.19 6.37 22.61 4.19 3.40 3.17 3.11 2.94 2.45 2.85
Days with the largest percentage decrease Date Points % 19-10-1987 28-10-1929 29-10-1929 06-11-1929 18-12-1899 12-08-1932 14-03-1907 26-10-1987 21-07-1933 18-10-1937
508.00 38.38 30.57 25.55 5.57 5.79 6.89 156.83 7.55 10.57
22.61 12.82 11.73 9.92 8.72 8.40 8.29 8.04 7.84 7.75
Source: Financieele Dagblad 5 June 1999. Permission to reprint granted
conclusions. But, first of all, it is necessary, briefly, to summarise some aspects of the options market.
Options Markets An options contract gives the holder of it the right, but not the obligation, to buy or sell securities or commodities at a specified price — the exercise price (also called the strike price) — on, or before, a given date (the expiration date or maturity date). Note that an option gives a right — but not an obligation. Options to purchase securities are termed calls; options to sell are known as puts. The individual issuing an option is called the seller. The original issuer of an option at the very beginning of its life is called the option writer. Having bought an option from the original writer, the purchaser may, later, decide to sell on the option to another purchaser so that the option may be sold on once, twice, thrice or many more times, rather like shares sold on in the European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
stock market. The individual purchasing an option is called the buyer. On the Amsterdam Options Exchange, as in other options markets, banks, financial institutions and high net worth individuals act as options writers. In return for being the original seller of new options contracts, they receive a fee from the purchaser — this fee is called the option premium. If the purchaser subsequently sells on the option contract to a third party, he or she, too, receives a premium from such a sale. Hopefully, the fee that he or she receives exceeds that previously paid to the option writer. Original options writers are market makers, holding themselves open to quote prices on a range of options contracts. In our story, the options that were at the centre of the turmoil were options on the level of the Dutch stock market (the AEX). Option pricing is a subject of more than moderate complexity. The good news is that there is a math287
THE AMSTERDAM OPTIONS EXCHANGE IN 1998
ematical model — the Black and Scholes model, for the development of which a Nobel prize in economics was awarded — that explains the level of the option premium. And the very good news is that, in this paper, we are not going to focus upon the math underpinning it. Suffice to say that there are five drivers of option premium value in respect of a nondividend paying stock and these are: ❖ the share price of the stock (called the underlying asset) upon which an option is written. In the case in point here, the underlying asset was the Dutch stock market index ❖ the exercise price of the option ❖ the time to maturity of the option ❖ the volatility (a measurement of the expected extent of upward and downward movements) of the underlying asset in the period to maturity ❖ interest rates until maturity of the option How movements in these five value drivers affect the option premium are summarised in Table 2. Note, from the table, that three of these value drivers have an opposite effect for the call option vis-a`-vis the put option. This is not the case with volatility and time-to-maturity. A lessening of the time-to-maturity reduces the value of both the put as well as the call option. The same effect is true for volatility. Turmoil in financial markets translates into higher volatility for the underlying asset and, therefore, results in an increase in the value of both put options and call options. As of early 1998, following the long upward rise from the early eighties, (with the exception of the hiccup in October 1987) — see Figure 1 — equity markets could be described as being quite bullish. Investors were still substantial net buyers of shares. To limit their downside risk, they were also increasingly buying put options on these underlying assets. What does this mean? And how does it work? Investors with portfolios of ordinary shares might not want to liquidate their investments merely because they perceive that downside risk is increasingly Table 2 Value Driver Movements and Option Premium Effects The variables
Rise in variable Influence on a call option
Share price (underlying asset) Exercise price Time-to-maturity Volatility of share price Interest rate
288
Influence on a put option
Increases
Decreases
Decreases Increases Increases
Increases Increases Increases
Increases
Decreases
apparent. Indeed, this might be particularly so if the equity market continues its upward momentum. But the portfolio might be hedged without unloading any shares — and this might be achieved by dealing options. Imagine that the ordinary share index is at 650. By buying a put option on the index at 650, the possession of such an option gives the purchaser the right (but not the obligation) to sell out at 650. Imagine further that, when purchased, the option has six months to run to maturity. This gives the purchaser protection against adverse stock movements for six months — or for a shorter period if the holder sells on the option. If, just after three months were up, the market level had fallen to 600, the option holder might sell his option at a profit of 50 points (650 minus 600). Of course, remember that the option purchaser held a portfolio of equity shares. Their prices will, most likely, have fallen — so the unrealised loss on the equity portfolio would be offset (not exactly but, hopefully, approximately) by a realised gain by selling on the option on the stock market index. Of course, had equity shares risen during the three month period in which the put option purchaser held the option, he or she would simply not have sold on the option but would happily have sat on the gain in equity shares.1 Buying put options limits downside risk (at the cost of the option fee, or premium) but keeps open upside potential. So, in early 1998, investors who felt that share prices would rise, but also saw significant downside potential, bought put options to protect their portfolios. Of course, investors, convinced of further rises, without excessive downside, might simply have bought call options — or, indeed, equities in general. In early 1998, activity in the Amsterdam equity option market was pronounced. Market makers were obliged to write put and call options as counterparties for investors seeking portfolio insurance. Besides this, 1996 and 1997 had witnessed the successful introduction of several large ‘click-funds’ (click-fondsen). These click funds are investment funds that invest in certain stock indices. At the same time, these funds also guarantee that should the index rise by a certain percentage then the capital gains will be clicked — or frozen — at that higher level. This strategy seemed attractive to risk-averse investors. It means, in fact, that with the purchase of a share in the click-fund, one actually invests in an index (representing the level of the stock market) and buys a put option on that index at the same time — a put option with an exercise price which is higher than the initial price. The managers of the click fund will wish to transfer the fund’s risk to the market makers — so it deals options on the index, in the manner suggested. Market makers, who are, of course, option writers, European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
THE AMSTERDAM OPTIONS EXCHANGE IN 1998
settle their transactions through so-called clearing members of the options exchange. Clearing members guarantee the credit worthiness of option writers. As part of this process of ensuring that option writers deliver in accordance with their obligations, the option writers have to deposit funds — called margin — based on a percentage of the market value of open options contracts. Note that the market value of put options will increase if the stock market levels fall. Clearing members are often subsidiaries of banks. A clearing member supervises the position of a market maker. The financial strength of clearing members should ensure that options contracts are honoured. The summer of 1998 witnessed a turn of events — a decline in stock prices. Although the fall in 1998 was nowhere so precipitous nor so extensive as in 1987, there was a series of multiple shocks extending over a longish period of time and pushing financial markets into turmoil during this period. And, in August of 1998, volatility of stock prices rose sharply — see Figure 2 — which, in turn, caused option prices to rise. This had an adverse impact on option market makers’ cash flow positions. They were forced, by the rules of the Amsterdam exchange, to pay in more funds to meet the margin requirements discussed earlier. Furthermore, the fact that the stock price index was falling meant that all of those put option contracts, taken out by investors to protect portfolio positions, were gaining in value and, consequently, resulted in more margin calls for option writers. They were facing a double whammy of margin calls. This created problems.
The Policy Approach by the Dutch Financial Authorities Given that the options exchange was much smaller in 1987 compared to 1998, the margin problems that
manifested themselves latterly were not there in 1987. The sharp decline in share prices on a worldwide scale in October 1987 led financial authorities everywhere to respond rapidly and, almost, in unison with a similar strategy — central banks (including the Dutch Central bank) infused muchneeded liquidity. Many small- to medium-sized banks around the world owe their survival to this intervention, which contained the possibility of a domino effect crisis in the banking sector. The turmoil in 1987 financial markets is dramatically tabulated in Figure 2 which shows daily standard deviations (volatility) of stock prices. The figure also shows that the 1998 turmoil was less pronounced but more prolonged. This latter point is relevant in the rest of our story. Early in 1998 — before the October crisis — Dutch supervisory and regulatory authorities were worried about the effects that increased option activity and heightened volatility (see Figure 2) might have. They were concerned to protect purchasers of options against the possible inability of option writers to meet their obligations. They did this by requiring option writers (market makers) to increase their threshold of position and credit requirements. Effectively, this meant that they would have to put up a greater percentage as margin — even on open contracts already entered into. The objective was to reduce chances of default by market makers. This action was taken early in 1998 and, because the share price decline was a slow and gradual one, the problem for market makers was, initially, containable. Table 1 shows that there were many days in the summer of 1998 which showed big drops in share prices in absolute terms, although none compared, in percentage terms, with Black Monday, 19 October 1987. However, as declines mounted in September 1998, difficulties multiplied. Remember, as markets fall, put option values rise — and, in the Amsterdam options market, so did margin calls based on a per-
Figure 2 The Standard Deviation of Dutch Equities (Based on the Herbeleggingsindex — see Figure 1)
European Management Journal Vol. 19, No. 3, pp. 286–290, 2001
289
THE AMSTERDAM OPTIONS EXCHANGE IN 1998
centage of the value of open option contracts. Furthermore, these margin requirements were magnified under the new rules. Severe liquidity problems arose. Positions that were easily maintainable earlier in 1998, now became precarious. In the first week of September 1998, a subsidiary of ING (The Netherlands’ second largest bank), called Extra Clearing, was facing extreme financial difficulties. This clearing institution was confronted with two market makers that were not able to meet their margin requirements. Extra Clearing could do two things. Either, it could liquidate the positions of the market makers concerned. Since these market makers were net writers of put options on the level of the stock market, this would crystallise losses and, possibly, lead to financial difficulties for other market makers — in a domino effect scenario. Or, a second possibility would be for Extra Clearing to extend more credit to the market makers concerned. Extra Clearing chose the second course of action. But, a continued decline in equity prices made this extension of credit activities get further out of hand. ING, itself, was forced to intervene, at great cost. The losses that were made public were estimated at up to NLG 75 million — that is, almost USD 40 million. Was this just the tip of the iceberg? Probably, as subsequently indicated by figures in the published accounts. The capital base of Extra Clearing was replenished and the exposures of several market makers were taken on by ING itself. The option positions, which were mostly in AKZO Nobel (one of Holland’s top ten stocks) and de Arnhemse (an investment company with large holdings in AKZO Nobel), were, in part, liquidated. This, in turn, affected the share price of AKZO Nobel. And, in 1999, ING decided to put in a bid for de Arnhemse — probably all driven by the options market crisis and its handling by Dutch supervisory and regulatory authorities.
Conclusions The ‘solution’ promulgated by the authorities to deal with the problem in the options market in 1998 actually increased financial turmoil, rather than calming it down. Unfortunately, the authorities did not react in the same manner as the Dutch Central Bank had in 1987. Of course, the Dutch Central Bank is detailed, amongst other things, to serve the public interest. Clearing members of the options exchange only serve the interest of their clients — that is, the market makers. Based on the evidence that we have seen and summarised here, we would seriously question whether regulatory and supervisory authorities in The Netherlands were sufficiently on the ball in 1998. Certainly, having initially come up with a ‘solution’, continued monitoring of developments through the summer and, particularly, into the autumn of 1998 should have made it clear that adjustments to the prescribed policy were necessary — and they were needed quickly. But, nothing happened. We had a new stimulus — but no response from the authorities. Financial regulators need to remember that it is occasionally necessary to take preventative and corrective action — but it is necessary, then, continually to monitor the consequences of such action and to change it, if necessary. The moral of this particular tale is equally applicable to other parts of our geographical and social world and to other, similar, bail-out situations. And, of course, it is really what control system mechanisms are all about. We forget this at our peril.
Note 1. Cognoscenti of options will know that, in reality, the option might have been sold on for time value.
ANDRE´ DORSMAN, University of Nyenrode, Straatweg 25, 3621 BG Breukelen, The Netherlands. E-mail: a.dorsman@nyenro de.nl
ADRIAN BUCKLEY, Cranfield School of Management, Cranfield University, Bedford, MK43 0AL. Email: adrian.buckley@ cranfield.ac.uk
Dr Andre´ Dorsman is Professor of Finance and Investment Analysis at the University of Nyenrode and linked to the Free University, Amsterdam. His teaching focuses on investment analysis, performance measurement and financial instruments. He has written two Dutch textbooks: Vlottend Financieel Management and Vermogensstructuur en Vermogensmarkt (Kluwer, 1999). A recent book, Gestion Financie`re, was published for the Belgian market (Standaard, 2001).
Dr Adrian Buckley is Professor at Cranfield School of Management and Visiting Professor at the Free University, Amsterdam. His teaching and research interests include international finance and real operating options. He is author of a number of finance textbooks, of which Multinational Finance, now in its fourth edition, is the most wellknown.
290
European Management Journal Vol. 19, No. 3, pp. 286–290, 2001