China Aviation Oil –Financial

Derivative Mishap

Presented By : Group 3

Ankita Khare-42
Divya Sahijawani-3
Himani Goel-02
Ishita Jain-52
Jayant Chhabra-30
Pallavi Jain-06
 Introduction
• China Aviation Oil (CAO) announced in the fourth quarter
of 2004 huge losses on its speculative commodity
derivatives position.
• The position had been rolled over already several times, to
avoid the realisation of mounting losses due to rising oil
prices.
• The Company finally faced margin calls that it could no
longer satisfy. This liquidity crisis triggered the disclosure of
the problem.
• It was one of the biggest business scandals in Asia after
Barrings Bank scandal in 1995
 About the Company
• China Aviation Oil (Singapore) Corporation Ltd (CAO) is the
Singapore subsidiary of China Aviation Oil.
• Incorporated in 1993 , Dealing in jet fuel (kerosene)
procurement for the airports in the People’s Republic of China
and international oil trading.
• The firm commands a near 100% market share of the
procurement of imported jet fuel for China's civil aviation
industry.
• Public attention in 2005 due to a trading scandal, involving its
chief executive Chen Jiulin with losses running up to $550m and
the subsequent collapse of the company.
• Initially, only swaps and futures were traded then came option
trading followed by speculative option trading.
• Unable to meet some of the margin calls arising from its speculative derivatives trade November
• Closing of the position with some of its counter parties 2004
• Losses amounted to US $390 million , Unrealized losses of US $ 160 million
October
• International oil Prices surpassed the $38 Price 2004
• CAO facing significant margin calls on its open (short) derivative positions
• Trading strategy was changed – bearish view of oil prices Q4 ,2003
• Speculative bid on oil for $38 per barrel assuming oil price would not rise above that price.
• Sold calls and bought puts - Short Position
• Speculative Options Trading March 2003
• Purchased Calls and Sold puts -creating a geared Long Position
• The Calls purchased were exercised instead of the puts .
BACK GROUND
 The Reason for Debacle
• Singapore Companies followed FRS (Financial Reporting
Standards)
• For the accounting periods under review , FRS didn’t prescribe
a method of recognizing and measuring derivatives.
• CAO adopted an incorrect valuation methodology for its
options. It regarded the intrinsic value as the fair value of its
options.
• Fair value of options should comprise both intrinsic value and
time value hence reported earnings were grossly inaccurate
 How The Collapse Happened
• No properly defined risk management policies in place.
• Lack of oversight by the senior management.
• The option contracts, some of which had complex features such as
optional term extensions, were not valued according to best
practice.
• In the Valuation Approach CAO didn’t consider time value of money.
• CAO continued with its valuation approach (using only intrinsic
value), even though the confirmations of counterparties contained
significantly different prices.
• Leading to erroneous financial statements.
• Several roll‐overs of loss generating positions, whereby options on
larger volumes were being sold to generate sufficient funds to settle
the existing position losses.
 Is option Valuation to be Blamed?
• The China Aviation Oil situation view, provides support for the new
approach to derivatives accounting both under IFRS and US GAAP.

• Derivatives not on balance • IFRS 7 Financial Instruments

sheets.
• Gains and losses accounted
upon settlement of the
derivatives.
• Investors don’t have sufficient
insight into the current position
or risk exposure of the company.
Disclosures
• Proper Sensitivity Analysis
• Provides Investors and analysts
with insights into the dynamics
of value changes and the
sensitivity of fair value to
underlying drivers

Historical Later
Treatment Treatment
Steps to be Taken for Good Governance and
Risk Management
• Defining the strategic objectives and risk tolerance of the
company
• Role Of Senior Management
• Independent Department
• Best practice of both internal and external reporting (financial
statements)
• Stress Testing : The assumptions underlying both the strategy and
the valuation and risk measurement models should be challenged
on a regular basis
• An In- depth analysis should be conducted on the risk profile of
the product, the appropriateness of its use, the capacity to
handle the instrument operationally, including the accounting
treatment
 CONCLUSION
• Derivatives mishaps, have nothing to do with the
inherent dangerous character of derivative instruments.
• The case is more a consequence of bad governance and
poor oversight, allowing ill-conceived and poorly
defined strategies to run out of control.
• Any financial management activity, well defined rules of
the game doesn’t guarantee exceptional results but
creation of at least accountability so that realised
returns can be assessed and understood within the set
objectives
 THANK YOU
Derivatives are financial weapons of
Mass Destruction – Warren Buffet