A trip to the Tripoli casino Q. How do you tell the $65bn sovereign wealth fund of a notoriously erratic government that it might lose all its money on trades you arranged for them? A. Very carefully. When the official told his boss that the entire investment could be wiped out, his boss responded: "We are not running a casino." NYT Dealbook, Oct 29 Earlier this week, Goldman Sachs said it would disclose how much profit it had made on some derivatives trades. Which is not something you see every day. Banks don't normally have an obligation to disclose profits to clients. The difference would be that Goldman was saying this to Mrs Justice Rose of the High Court - in a pre-trial hearing held on Monday as part of the Libyan Investment Authority litigation. The LIA has been suing Goldman, and also Societe Generale, over losses on investments of circa $1bn and $2bn respectively which it made with them just prior to the financial crisis. The Goldman investments, for instance, were a series of nine equity derivatives trades made in the first half of 2008. There was also one last FX derivatives trade which is not part of the lawsuit. In Monday's hearing, the LIA estimated Goldman's profits at $350m. This is a long-running saga. But on these pixels, we recall covering the travails of the LIA years ago - during and after the overthrow of the regime of Muammar Gaddafi, which had set the fund up and filled it with Libya's oil revenues. There was, for example, the surprising extent to which the young SWF's assets had seemed to comprise alternative assets and derivatives versus plain equities or bonds in the first place. More recently meanwhile, we've looked at how banks disclose profits and losses on complicated transactions where public entities are the clients - and especially at how the initial structure of such transactions is presented. Which brings us to the Dealbook quote. Dealbook's story was previewing the next moves in the case in general. The above quotation is an interesting encapsulation of the issues involved in that disclosure to clients, and the structure of Goldman's nine trades with the LIA. The official in question was from the LIA, obviously. The investment meanwhile was that last FX option trade in May 2008. This specifically involved a three-year bet on several emerging-market currencies - organised in one basket. Considering the complexity of its moving parts, this trade was a simple call option. Which was the problem. The LIA seems not to have known how call options worked. This includes recognising the possibility that call option trades can lose the amount invested if the price of the underlying asset is below the strike price at the end of the trade. QED - the response of the boss after the official sought advice on how call options do actually function, after being confronted with one in the FX term sheet. Whether the LIA was sophisticated enough to know what it was buying from investment banks is of course central to this case. Particulars of claim filed for the LIA in January quite baldly allege that it was "financially illiterate," for instance. But what is especially piquant for our purposes, however, is that the LIA had already invested in several call options. These would be the nine equity derivatives trades prior to the FX one - options on the three-year performance of share prices from Eni to Allianz, Santander to Citigroup (on which the LIA made two trades). We'll focus on just the first Citigroup trade - the term sheet of which we've reviewed. The LIA entered this trade on 24 January 2008, having paid Goldman a premium of $100m for the privilege of betting that 11m Citigroup shares would rise above a strike price of about $27. We'll come back to that strike price. Our first focus is on the trade's structure. 1) When is a call option not a call option? As an annex to those Particulars of Claim also points out, the first Citigroup transaction was a somewhat unusual mix of two trades. It combined a simple forward bet on Citi's future stock price with a put option on the same stock. Here's how the annex describes it: Based on the term sheet's description, we can also present the payoff to the client this way - as the sum of: Forward payout = number of shares x (final price - strike price) Put payout = number of shares x the greater of zero or (strike price - final price) Economically, this is a call option. If the final price had risen above the $27 strike, the LIA would have collected a payout on the forward (minus the premium it had paid) when settling the difference with Goldman. That would have meant not exercising its right under the put option. The total would be the same as actually exercising an in-the-money call option. This is thanks to a little thing known as put-call parity. This also works vice versa. Losing money on the forward would mean that the LIA made up the loss by exercising its put option with the same strike price, thereby not exercising a call option. Did the LIA know what it had bought, 9 times over half a year, was economically the same as a series of call options? Apparently not, going by the "casino" reaction to the first normal call option it had encountered in the FX trade. We understand that part of this might be because the LIA considered a forward position to confer actual ownership of the underlying shares in some way. Certainly this paragraph of the Particulars of Claim suggests some fogginess in this area (emphasis ours): Within the LIA there was confusion as to the true nature of the Disputed Trades, both prior to and following their execution. In particular (and without prejudice to evidence that will be adduced at trial), up until July 2008 (and the facts and matters referred to below) both the LIA board of directors and employees did not properly understand whether the Disputed Trades involved direct equity investments, or a species of quasi-share ownership, or constituted an entirely synthetic financial instrument; and/or misunderstood the true position. There's a simpler question to be asked. Why didn't the LIA just enter into a simple call option in the first place? This is unclear. But one simple thing we'd note is how a call option formula typically looks on a page: Number of shares x the greater of (final price - strike price) or zero How would the LIA have reacted to being directly told, in print, that it could get zero for its investment? We think that's a good question. 2) When is a scenario analysis... not one? As we note above, the other issue with the Citigroup trade is its strike price, which was about $27. In hindsight, it was not a terribly good idea to invest in the economic equivalent of a call option on Citi's stock early in 2008, especially one which was only in the money above $27. Less than a year later of course, Citi was trading at less than $1. But we want to focus on what foresight the LIA was given by Goldman at the time of its trade. This would be in the form of Goldman's scenario analysis of transaction payoffs for various potential Citi share prices at the end of the trade ("for indicative purposes only," admittedly.) From the trade documents, here's that scenario analysis in chart form (click to enlarge); The first thing to note is that even at $32 - requiring Citi stock to rise a fifth above the strike price - the LIA would have lost almost half its cash. It would only have broken even after $36, an increase of a third. The second thing to note is that the scenario analysis only starts at $32. Not only does the analysis omit the payoffs between $27 and $32 - which would have proven even more disadvantageous than the LIA losing nearly half its money - no scenario exists where Citi's shares ended below the strike price, which was near to Citi's actual share price at the time. Downside of that nature would surely not have been impossible over three years - even if a once-in-a-generation financial crisis hadn't intervened and blown up Citi stock anyway, leading to a US government bailout for the bank. Anyway, the litigation continues. The case is at heart about client disclosure. This particular Citigroup trade seems to demonstrate something fairly simple, but perhaps easy to forget. Lots of disclosure can be provided for any complicated derivatives trade. That doesn't mean it's the right disclosure. Related link: Libya-Goldman clash sheds light on fund - FT