Managing Risk Exposures With Futures: Principles, Procedures, And Strategies

The Importance of Managing Risk Exposures

Barings Organisation was able to identify the overall Fraud conducted by Nick leeson after the accumulation of 827 million GBP losses in futures contract. Nick leeson was considered as one of the most reputed individual in Barings organisation, where he held A significant position in Singapore branch. He was only responsible to conduct arbitrage trades between the currency markets.  Nick leeson mainly used the speculations in futures market to increase its overall gains from rising Nikkei shares. However, from the start of 1992 Leeson was facing loss from the futures contract, which started to accumulate day after day (nickleeson.com, 2017). The figure 1 mainly helps in depicting the doubling trading strategy, which was used by Nick leeson for conducting future trades. According to the strategy, investors are relatively losing more money than gaining from the futures market. For hiding, all its losses Nick leeson used a fake account number of ‘88888, where it stored all the relevant losses incurred from futures contract. This measure mainly helped Nick leeson to hide all the relevant losses from the management of Barings organisation. The major turning point of the losses incurred during 1995, where Nick leeson was long in the futures of Nikkei and JGP, when an earthquake hit Japan shedding 1000 points from Nikkei futures. This mainly resulted in high losses incurred by Nick leeson during 1995. However, after the losses, Nick leeson added more futures contracts in his portfolio, which relatively increased the overall losses to 827 million GBP. The losses incurred in futures market resulted in the liquidation of Barings bank in 1995 (nickleeson.com, 2017). Therefore, it could be understood that greed and pride of one individual mainly dissolved a 300-year old bank.

Future contracts are mainly deemed as a legal agreement between two persons, who have promised to buy a particular commodity or share at a given price on certain date. Future contracts are mainly conducted by an organisation to effectively reduce the negative impact from changing price volatility (Hamilton & Wu, 2014). Investors by using the future contracts are able to effectively reduce risk from the price volatility and hedge their position.

Investors while using futures to manage their risk exposures use the following principles.

• Companies with the help of future contract are mainly able to cover their overall exposure in the market. The futures contract mainly acts as a cushion for the Company as it helps introducing the negative impact that might have on its investment.
• Future contracts are mainly based on physical products such as commodity or shares. The change in the underlying physical market price could also change the overall future contract value (Anisimova, 2014).
• With an adequate example, the mitigation of risk perspective from the futures contract could be identified. For example, an increase in copper prices in the physical market could eventually decrease the future contract value, as it helps in reducing the risk from price uncertainty. Future contracts effectively help investors to hedge the current exposure in the physical market, which could hamper from changing volatile prices.

There are different types of rules, which need to be evaluated before conducting any kind of risk management strategies. These rules mainly form of basic Uses of futures contract that are conducted by investors to hedge their current position. Investors use future contracts for reducing any kind of risk that might arise from operations. In addition, the future trade concept mainly allows investor to buy or sell the physical commodity at certain date by nullifying the impact of price volatility. Furthermore, investors use the future contracts to freeze the current prices for particular commodity shares, which help in mitigating the risk of rising prices (Simon & Campasano, 2014).

Basic Principles of Future Contracts

For example if a company intends to sell corporate bonds in the market, it needs to hide itself against in the negative impact from pricing interest rates. The company could short future contracts that cover interest rate risk exposure, which will help in reducing any kind of risk that might arise from volatile interest rate. Until the corporate bonds are issued, the company could hold the short position in futures contract, which might help in raising the adequate capital intended by the management (Szymanowska, Roon, Nijman & Goorbergh, 2014).

However, Nick leeson did not use the risk mitigation factor, which could have reduced the overall risk from investment in futures contract. Nick leeson mainly focused in buying futures contract without any adequate risk measures, which resulted in huge losses incurred from the fall of 1000 points in Nikkei index (nickleeson.com, 2017).

The future contract buying procedures needs to be followed by all the relevant investors who intend to use future contracts (Hodrick, 2014). There are relevant measures that it needs to be followed by investors while buying future contracts, which are depicted as follows.

• The future contracts are mainly traded with the help of an exchange and a broker who submits the order of the investor to the exchange for processing.
• The buyer of the future contract mainly contacts a broker for placing the order on a certain commodity or stock. Without the help of proper channel the investment, in future contract cannot be conducted (Chinn & Coibion, 2014).
• This change effectively uses open outcry method in the exchange floor for matching all the relevant buys and sells of a particular future contract. This electronics method of trading mainly helps investors of futures contract to smoothly conduct buying and selling process.
• Moreover, for buying the particular futures contract relative margin call needs to be maintained by the investor, as without margin call, exchange does not allow any future contract to be traded. Therefore, with the payment of initial Margin Call investors could buy future contracts from the exchange with the help of a broker (Beckmann & Czudaj, 2014).

There are relevant implications of both long and short future contracts, which need to be followed by investor while conducting investment. The following implications need to be followed by investors while conducting future trades.

• Investors having long position in the futures contract have relative risk of loss when prices of the contract decline. Similarly, investors having short position in the futures contract have relative risk of loss when price of the contract increases. In both cases if loss incurs then margin calls are violated, which then needs to be maintained by the investor (Sevi, 2014).
• In case an investor has a long position in the futures market, then he is obliged to buy the required commodity at the end of the delivery date. Similarly, if the investor has a short position in futures market, then he is obliged to sell the required commodity at the end of the delivery date. Clearinghouses are mainly responsible for delivering all the relevant attributes of a contract made between two individuals.
• Furthermore, investors from both short and long position future contract have to maintain a regular margin call for its exposure in the futures market. Without the maintenance of margin call investors cannot conduct any kind of transactions in the futures market according to the exchange.

With the help of adequate measures, investors are able to close the overall future position before the delivery date. The measures that could be used by investors in closing the future position are depicted as follows.

• The investor could conduct opposite contract before the closing date or the delivery date of the futures contract. Investors could effectively use an opposite contract with same quantity to nullify the overall agreement made with the exchange regarding supply for commodity. This measure mainly helps investors to benefit from the spread that is obtained from purchase of the future contract and sale of the future contract. The difference between the values is the mainly the profit, which is obtained by the investor from conducting trades in future market (Daskalaki, Kostakis & Skiadopoulos, 2014).
• If the investor takes long position in a future contract, which is about to expire in few days and he does not need the relevant commodity shares. Then the investor could effectively take short position before the delivery date. Majority of the investors that does not want to be commodity or stock but just trading again profits from the spread mainly uses this measure.
• Similar features could be used in future contracts that is been shorted by investors, in this case investor has to provide the commodity or stock to the exchange after the delivery date. Thus, taking a long position would eventually help the investor to rely on the overall spread created from the investment date.

The evaluation of Barings bank scandal mainly portrays the lack of adequate measures that was taken by the management to ensure ethical operations in the organisation.  The management was too lenient with Nick leeson, as he provided a prominent growth in future.  Nick leeson saw the opportunity and the low internal control imposed by management of Barings bank and took relative steps to enhance of further his career (Barndorff-Nielsen, Benth & Veraart, 2014). The Barings Bank management failed in three different levels, which could have helped the organisation to attain sustainability. Firstly, the management reduce the overall control in Singapore branch and made Nick leeson the head derivative trader (nickleeson.com, 2017). The management did not appoint any further heads in Singapore branch with good monitor new transactions conducted by Nick leeson. Moreover, the management also failed to arrange independent risk management units, which could evaluate the overall operations of nick leeson in Singapore. This could mainly help the bank to catch the unethical measures conducted by the prodigy of Barings Bank, which resulted in the insolvency. Lastly, the Barings management was not able to identify the hidden account of ‘88888’, which was used by Nick leeson to hide all the relevant losses obtained from futures contract.  Strong control of the management on the operations and relative expenses of Singapore branch would eventually helped in identifying the wrong doings conducted by Nick leeson, which in turn could have saved the bank from liquidation (nickleeson.com, 2017).

Using Futures to Mitigate Risk

The occurrence of an unexpected activity, which might hinder the continuation of business are mainly known as risk. The overall risk mainly hampers the activities of company by increasing the negative impacts on organisational performance. The nature of risk is mainly identified as follows.

• Organisations mainly comprise of both operational and financial risk that could hamper its activities. These activities mainly reduce ability of the company to ensure continuity of activities and attain sustainable profits (Aruga, 2014).
• Furthermore, it is also evaluated that any increment in the uncertainty of operations mainly reduces ability of the company to effectively forecast future operations.
• The operational risk directly handles the functionality of the organisation, while financial risk directly affects liability, Assets and cash flow the company.

The main purposes of the risk management are mainly depicted as follows.

• The use of risk management allows companies effectively identify and isolate the risk which might hamper its operations
• Risk management also helps in depicting the relevant outcomes that might be portrayed by the risks involved in business decisions (McCredie, Docherty, Easton & Uylangco, 2014).
• Furthermore, risk management also helps in mitigating both operational and financial risk that might hinder activities of an organisation.
• Lastly, with the help of risk management organisations are able to identify all the risks that might affect its operation and reduce its ability attain sustainable growth.

The responsible personnel who can established the overall risk management objective policies and procedures in an organisation are mainly depicted as follows.

• The overall documentation of the entire risk objectives are mainly conducted by the board of directors. The directors are responsible for identifying all the relevant activities, which might negatively affect operations of an organisation and enlist it within the risk documentation (Weron & Zator, 2014).
• The completion of the documentation results in identification of relevant risk factors, which are derived by the directors of an organisation. This derivation of the overall operations could mainly help in identifying the risk factors, which might affect capability of the organisation.
• Furthermore, with the use of executive management and executive officers the organisation is mainly able to identify the procedures, reporting structure, and strategies that might help in reducing negative impact from identified risks.
• Lastly, the directors with the help of the fine structure and strategies are able to limit the impact of identified risks and attain sustainable growth (Schorno, Swidler & Wittry, 2014).

The overall evaluation of Barings bank could eventually help in identifying the need of adequate risk measures, which could help investors during investments. In addition, the case of Nick leeson mainly states the non-accommodation of risk attributes, which was affecting activities of Nikkei index.  Nick leeson mainly behaved as a novice trader, And did not effectively has its exposure in the futures market. Moreover, the loss incurred from the earthquake in Japan, resulted in use losses conducted by Nick leeson. However, Nick leeson instead of covering the losses increased its exposure in the Nikkei futures, which resulted in immense loss and amounted to 827 million GBP (Lee, Stevenson & Lee, 2014).

Hence, evaluating the actions of Nick leeson, adequate risk measures needs to be conducted by investors before investing in any instrument. The identification of risk could have helped Nick leeson to hedge its overall exposure in Nikkei futures and reduce the overall losses incurred from investment. Therefore, it is essential for investors to effectively identify the overall risk from investment, and take adequate measures, which could help in reducing any losses incurred from volatile prices.

The main function of capital is to provide adequate leniency to the organisation in conducting its business activities. Moreover, the use of capital allows investors to conduct investment activities, which could help in increasing the overall returned from investment. However, the case of Barings bank is also same, as Nick leeson after running out of money mainly left Singapore leaving a note stating ‘sorry’. Huge losses incurred by Nick leeson in futures contract mainly declined the capital of Barings Bank, where Leeson was not able to provide any for the amounts to support margin calls. This mainly led to the rising loss incurred from investment (Hedegaard, 2014). Therefore, it could be identified that capital is an essential part of investment, which is required to effectively continue with the operations for business.

Credit risk could be defined as the overall risk of investment, where the borrower does not pay the borrowed amount to the lender. Therefore, credit risk arises when borrower is not able to pay adequate money to his lender, as per the agreement. The capital requirement of basil to Capital accorded affected as follows.

• Half of the overall capital needs to be under Tier 2 section  and Tier 1 section of Basel II, which comprises of the minimum capital of a bank.
• According to the prudence standard requirements, Institutions are mainly needed to have a constant maintenance of risk capital ratio at 8% (Sbarcea, 2014).
• According to be regulated the institution also need to have wrist based weights of all the assets, which should mainly comprise a minimum capital ratio of 8% according to the Basel II capital accord (Chen, 2014).

Buying and Closing Future Positions

For example if a bank provides a loan of 150000, for a company with the rating of A.  The minimum Capital requirement by the bank for the related company is depicted as follows.

Before with the minimum Capital requirement of 6000 loan of 150000 could be passed by the bank according to the Basil to minimum Capital requirement Accord.

The above table mainly depicts the relevant minimum capital requirement under Basel II and Basel III (Wang, 2014). Therefore, additional attributes are mainly used in Basel II for reducing the overall risk from investment could hinder banks credit ability. Moreover, the Basel III is mainly developed in 2013 to comprehend the limitation of Basel II, which could increase risk from minimum capital. In addition, the Basel III mainly allows financial institutions to identify capital, which has the least risk from investment. Moreover, it uses nine different types of categories for effectively reducing the overall risk from investment of financial institutions. The inclusion of Basel III allows financial institutions to reduce the overall financial risk, which might help in strengthen its solvency condition.

Moreover, Basel II was mainly discontinued due to the overall limitations, as it does not address three factors, which could help in addressing concerns of risky investment. In addition, the requirements in Basel II were mainly low, whereas it did not help in reducing the accumulation of risky investments by financial institutions. Moreover, Basel II is mainly identified as the international business standard, which requires financial institutions to maintain enough cash reserves for covering risk incurred by operations.

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