Sunday, August 5, 2012

Case study of barings bank

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In this case report, firstly, the arbitrage opportunities in the authorized trading which was supposed to exploited by Leeson and Lesson’s trading strategy will be focused on. Secondly, our interest is to find out the strategy on how to lose more money than Leeson did. As the more we know how to lose money, the more effective control for the investment we realize. In addition, the loose internal management in Barings Bank was also a critical reason for the collapse of Barings and lessons from that is worth discussing and referring by the present financial institute.

1. Arbitrage opportunities in trades

1.1 Arbitrage opportunities between Osaka and Singapore

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Nick Leeson was appointed to trade derivatives on the Singapore International Monetary Exchange (SIMEX) and the Osaka exchange, and hence was making a low-risk profit, known as “switching”. Obviously, arbitrage opportunities existed in trading Nikkei future contracts in the two markets, when there is different price and it is easy to make profit by purchasing future contract in the market with higher price and selling it in the market with relatively lower price. For example, as shown in the Table 1, on 1st,November 14, the price difference between SIMEX and OSX is 55, meaning profit can be realized by longing the Dec 4 future contracts in OSX and shorting it in SIMEX.

1. Arbitrage opportunities in future contract between Nikkei 5 spot and Nikkei 5 future

Another arbitrage opportunity appeared in the Nikkei 5 futures and Nikkei 5 spot. Firstly, assume that there is no transaction costs, the dividends are received on a continuous basis, and that the nearest Euro-yen futures rate approximates the Japanese short-term free-risk rate and the FFP of Nikkei futures contract was calculated by (results are stated in the table 1)


Assume that there is no transaction costs, the dividends are received on a continuous basis, and that the nearest Euro-yen futures rate approximates the Japanese short-term free-risk rate.

Where St= spot price of Nikkei 5 index

r= riskless interest rate,

D= dividend, a continuous 1% dividend yield on the Nikkei 5

�=fraction of a year from now to maturity. Here suppose the third Friday of exercise months as the expiration dates, which are 16 Dec 4, 17 Mar 5, 16Jun 5.

On one hand, when the actual futures price is higher than the fair value of the futures, we can gain by purchasing the spot assets and shorting the future contract. On the other hand, and when the actual futures price is lower than the fair value of the futures, the trading will be profitable by taking a long position in future contract and selling the spot assets.

1. Arbitrage opportunities between implied interest and riskless interest

In addition, the arbitrage opportunities can also be found by comparing the implied interest rate and the riskless rate.


Where Ft= actual futures price;

S= price of the spot assets;

q= dividend rate 1% ;

�= (T-t )/65 = fraction of a year from time t to T.

As stated in the material, if IRr, borrowing at the riskless rate and lending at the implied interest rate of the futures contract; if IRr, buying the futures contract and selling short the stocks in the index. For example, the IR of Nikkei 5 future contract in OSX on 7th, October 14 is .4%, which is more than the riskless rate, .5. The profit can be realized by borrowing the money at the riskless rate and buying the future contract at the implied interest rate.

From the discussion above, arbitrage opportunities are significant, but sometimes that is not the case. The trades are not free of charge, there are some transaction costs the traders have to pay, as well as tax. If the profits from above arbitrage opportunities cannot cover these trading costs, the arbitrageur will not proceed the trading. Besides, the data shown in the table is only the closing prices of the previous date. They can not reflect the fluctuation of prices dynamically during that day.

. Evaluation of Leeson’s trading strategy

Leeson’s strategy involved both buying stock-index futures and selling options on the Nikkei-55 index. Following the Kobe earthquake, the price of Nikkei futures contracts fell sharply. As Leeson thought the price was undervalued and was betting that Japanese stock price and interest would rise rapidly, he kept on expanding the long position on the future contracts. The relationship between future price movements of previous days and position adjustment was analyzed by using the historical volatility. As we know, historical volatility indicates the probability that the underlying security will move a particular distance measured in price on a given period. As shown in Graph 1, after the Kobe earthquake, the volatility tended to be fluctuant and the huge loss resulted became inevitable and catastrophic. Instead of cutting losses by closing out positions as the market declined after the Kobe earthquake, Leeson doubled up on his position. This means that the position adjustment by Leeson was not based on historical market data of previous days and he was just a gambler and tried to hold up the market by expanding volume.

As to option, Lesson executed a highly risky trading strategy known as “straddle”, making profit when markets are stable and resulting in huge loss when there is any sudden move in either direction. However, Leeson did not hedge his portfolio and was in hope that the market remained steady in order to gain the premium smoothly. If Leeson tried to use hedging strategy, e.g. Delta hedging to rebalance his portfolio and adjust his positions dynamically, the history of Barings would be changed.

. How to lose more money

.1 Losing trading rule

The reverse of Double-up trading rule

If [CP (T)-CP (T-1)]O, Then 0.5P (T-1), else P(T-1)

Refer to the material, the reverse of Double-up trading rules based on the previous prices to adjust position, can be used to lose money in Nikkei 5 futures more than Leeson over January and February 15. When the closing price of the future exceeds the last day closing prices, reduces the position to 1/ as much as currently held; when the closing price of the future is less than the previous day closing prices, doubles the position. That is, if you are holding 10000 positions of Mar 15 contracts in the Nikkei 5 on 16th, January 15 and the closing price is 145 which is 10 more than the closing price on 17th, January, cut down the position to 5000 as illustrated in Table .

. Losing strategy - Strip

Here taking the Jun 5 option on the Nikkei 5 future contracts as an example to illustrate the losing strategy over the first two months of 15.

Firstly, calculation of the fair prices of listed options is the foundation stone. By HULL’s software and the data from table and 4 on handout, the current levels of implied volatility of the two months’ historical volatility as shown graphically below Graph 1, from 10th October 14 to 1th September 14. Clearly, the implied volatility, 0.06, of OSX (JUN) option had a significant difference to the mean of historical volatility, 0.1140, of the OSX (JUN), which was consistent with the simple rule that when the relative implied volatility is lower than the average, the option is effectively under priced. Selling the undervalued options provides a high potential of losing in the following two months.

Secondly, the loss also rests with the price movement of the underlying asset, i.e. OSX (JUN). A normal trader makes a personal expectation, with empirical and academic analysis basis on the historical market performance and technical indicators, that the OSX futures market would be a bearish one. Basically, if betting that there would be a profitable underlying asset price movement, the trader considers a decrease in the asset price is more likely than an increase so that he probably to make a profit by purchasing a strip. For a loser with the similar expectation, inversely, he writes a strip, i.e. selling two put options and selling one call option of the SIMEX (JUN) option, which is under the assumption that the position in the futures contract was closed out immediately at the time the option was exercised. The result of the deal goes as follow. Profit from OSX (Jun5) Exercise Price=1000, Call Price=1074.55 Put Price=154.55

Range of Stock Price Profit from call Profit from Put Total Profit

St=1000 1074.55 St-760. St-6616.5

St=1000 08.65-St 0.1 06.75-St

Using the formula, when the price of OSX-NIKKEI futures (MAR) moved to 17000 on the 8th February 15, the negative profit of -616.5 (17000-6616.5) is experienced. So the loser suffers a 616.5 loss in the period by writing an OSX (JUN). (Refer to Guangzhen Sheng’s)

. Fooling activities

a. Fool the supervisors within the bank and the auditors

Try to use more complicated financial instruments with compound trading strategies, in order to let as few as persons as you can, including the managers to understand what you are really doing. Make sure you are the only expert of the areas in your company or team and make up you authority among your colleagues or team members. Just show them the P&L and other reports in which you can adjust all the numbers to what they should be.

Try to build up a tight relationship and friendship with all the key persons in each link, which will influence the implementation of your trading strategy. The accounting or financial report department is necessary to help you manipulate the financial statements. So either you yourself be a man in these departments or you should have the leadership of them.

b. Area Differences

Local regulators do not always have the same criteria as the parent authority, and they can not understand or agree with every aspect of the methodology of regulation. So compare with all the details and discover that exits in the host authority but not in the parent authority, vice versa. Then you can make explanations easily to both sides, especial to the parent side that your unconventional or abnormal operations were due to the host authority. (Refer to Shengzhang Jiang’s)

4. The lessons from Barings case

It was Leeson, once recognized as a “star trader”, furtively created a “error” account 88888 into which he put his lost of unauthorized trading transactions between SIMEX and OSE. Consequently, the account was run up to lose at $1. billion dollars and that eventually broke down the Barings as it could not sustain huge amount of margin calls. But Barings could not totally escape blame. Since the senior management allowed Leeson to control both the investment department and settlement department in BFS, as a result, he was able to conceal his unauthorized trading activities for over a year without detection. Even when the price of Nikkei futures contracts kept falling sharply, the bank placed too much reliance on Leeson and still wired him $1 billion to continue his trading. If the Bank implements well-divided job allocation, and the entire employee take seriously of their responsibility and report to the senior management systematically and authentically. Simultaneously, a series of integrated supervision function should be adopted to audit and regulate the whole operations of the internal management. For example, the bank should set up an independent group of auditors to check the balance sheet issued by the accounting department regularly and also, the members of that group should be substituted after a certain period. Besides, financial derivatives constitute an important part of portfolio executed in banks, financial institutes and Security companies, it is necessary for the management to understand the operations of all the instrument. And also the risk-control measures should be set up for all the trading activities, for example, the limits of the open interest, the limits for the arbitrage activities, exposure rules and so on. Finally, the Bank should develop extensive investment portfolio to distract risk.


The main conclusion in British report is pointed to failure of management to understand and detect activities being conducted within the group

The collapse was brought about by the unauthorized trading activities within BFS-one overseas subsidiary within a large group but whose activities accumulated losses of around 80 million pounds and caused the ultimate parent company, Barings plc, to be placed in administration. The collapse of Barings is an illustration of how a viable and prosperous group can, in circumstances where controls are ineffective, be brought down by unauthorized activities within one of its subsidiary operations.

From the case of Barings, we can realize how important for the parent company to understand and control the operations of its subsidiary company.

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