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China Aviation Oil Case Study
Transcript of China Aviation Oil Case Study
2005 China Aviation Oil corporation Ltd (CAO) embroiled with one of the biggest trading scandal involving its chief executive Chen Jiulin with losses running up to $550m and the subsequent collapse of the company.
2006, Chen was arrested with the charge of insider trading.
CAO expected oil price continue its trend upwards
Purchased calls and sold puts, created a long position
, calls exercised and made profit
puts not exercised and profited from premiums
CAO adopted a bearish view of the trend in oil price
Chen signed contracts with multiple banks and made a speculative bid on oil for $38 per barrel
Sold calls and bought puts
Oil price did not decrease
Monthly Imported Crude Oil Price
International oil prices rose steeply, leaving CAO facing significant margin calls on its open derivative positions.
Expect oil price decrease
increase trading volume
increase trading volume
accumulated losses $390m
unrealized losses $160m
conceal the losses
Improper application of accounting principles, and inadequate risk management systems.
Initially, only swaps and futures were traded to help optimise CAO’s procurement capabilities. Later, on behalf of client airline companies, back-to-back option trading was started.
Wrong bets on fuel prices in 2004, forced the company into a scandal which cost CAO dearly.
The CEO, Mr. Chen Juilin, was held responsible for the loss and arrested and charged with fraud
and failure to report losses and subsequently was fined $330,000 and imprisoned for over 4 years.
Lessons to be learnt
PBT: profit before tax
reported PBT: CAO valued options at intrinsic value and ignored time value of money.
Adjusted PBT: PwC report valued options with both intrinsic value and time value.
The mains six reasons of the CAO’s Huge Loss:
· The speculative option trading started without encapsulating properly in risk management policies and senior
management oversight and supervision.
· The option contracts were not evaluated on a best practice basis.
· With the fair value accounting, the errors in the valuation of the open position lead to erroneous financial statement.
· Current options were sold to generate sufficient cash and funds in order to settle losses on the existing position.
· The board of director did not fully implement the respective duties on CAO’s risk management and trading control.
· Company management intended to violate the risk management regulations
Better control and enhancement of risk management is necessary in order to avoid sharp, unprecedented and unexpected losses.
An independent risk management department which provides on the ground vigilance and responsiveness to ensure risk management policies are adhered to.
A team which has the required expertise to manage risk.
Build early-warning systems, which encourage employees to find potential risks and report them to management.
The financial reporting must follow the best practice with frequent and detailed disclosures.
In order to know the loss in different scenarios stress testing must be done.
One should not indulge in a market one does not have good knowledge of.