Business Snapshot 5.1 Kidder Peabodys Embarrassing Mistake

Part 1: Writing Report (a) Describe in detail the cause, process, and consequence of the case.

(b) What can we learn from financial disasters?

Investment banks have developed a way of creating a zero-coupon bond, called a

strip, from a coupon-bearing Treasury bond by selling each of the cash flows under[1]

lying the coupon-bearing bond as a separate security. Joseph Jett, a trader working

for Kidder Peabody, had a relatively simple trading strategy. He would buy strips and

sell them in the forward market. As equation (5.1) shows, the forward price of a

security providing no income is always higher than the spot price. Suppose, for

example, that the 3-month interest rate is 4% per annum and the spot price of a strip

is $70. The 3-month forward price of the strip is 70e0.04*3>12 = +70.70.

Kidder Peabodys computer system reported a profit on each of Jetts trades equal to

the excess of the forward price over the spot price ($0.70 in our example). In fact, this

profit was nothing more than the cost of financing the purchase of the strip. But, by

rolling his contracts forward, Jett was able to prevent this cost from accruing to him.

The result was that the system reported a profit of $100 million on Jetts trading

(and Jett received a big bonus) when in fact there was a loss in the region of

$350 million. This shows that even large financial institutions can get relatively

simple things wrong!

(a) In describing the cause and process of the case, students should discuss the key persons, dates, and events. Graphs, figures, or tables can be included in the report with appropriate citations.

(b) In discussing the consequence of the case, students should discuss the impact of the financial disasters in relating to other participants in the financial market and their reactions. For example, peer firms, shareholders, regulators, and so on.