Background on Nick Leeson story in relation to the Barings saga
Nick leeson was one of the star traders in Barings organisation, where he was responsible to conduct different types of transactions related to future, options and arbitrage. The main operations were mainly to use the arbitrage facilities to gain profits from the spread, which could help the bank to increase their profits. However, being one of the star traders in Barings organisation Nick leeson was mainly attracted towards futures contracts. Nick leeson was mainly one of the misfortunate traders who lost around 208 million GBP of Barings organisations from 1992 to 1994 in risky future trades (nickleeson.com, 2017).
Leeson mainly opened a secret account with the number ‘88888’, where all the losses was transferred and kept hidden from the management of Barings organisation. Before 1995, Leeson mainly made bad trades or bets, which increased the overall loss from 208 million GBP to 827 million GBP. This rapid accumulation of debt and losses was mainly hidden in the account number ‘88888’, which was only discovered after Leeson left a note in the Singapore office saying ‘sorry’ and fled the country. The major losses that were incurred by Leeson mainly came from wrong bets in Nikkei futures and JGP futures. Leeson mainly used these features to generate profits from markets. During 1995, due to earthquake Nikkei futures mainly declined 1000 points, instead of closing the losses Leeson purchased more futures to cover the loss. The novice traders mainly conduct this type of trading, where trades are conducted on emotional basis rather than concrete calculation. Leeson mainly fabricated gains obtained from investment, which was conducted to hide the staggering secret losses incurred from futures trade (nickleeson.com, 2017).
Contract that legally binds two individuals or parties for buying or selling of particular commodity with the help of financial instruments at a specific date and price is mainly known as future contract. This type of contract mainly allows investors to conduct future trades, which could help in reducing risk from price volatility in future.
The basic principles for using futures account to manage risk exposure are depicted as follows.
- Futures contract are mainly focused in reducing any kind of risk that is attached to a commodity or financial instrument. Management are able to hedge their position to reduce any kind of negative impact from volatile market.
- From the risk perspective scenario if prices of gold increases in physical market then the future contract value of gold will decline, thus removing or reducing risk from price uncertainty. This type of reduction in price in certain it is mainly conducted in future contracts to help reduce any arbitrage opportunity. The future contract provides a base for the investors effectively hedge for its future activities.
- Future contracts are mainly based on prices from underlying physical market, where is the actual prices of the commodity falls it is directly reflected on the future contract.
The specific rules that need to be followed while considering risk management strategy by contracts. The basic rule mainly states that Investor conduct future trade today, just for the intention of doing physical market trade in later date. This concept mainly helps in fixing the prices for a certain commodity and financial instrument, while reducing the negative impact of price volatility (Feng, Ming & CHANG, 2016).
Furthermore if a borrow plans to sell certain corporate bonds, then he needs to sell future contract to cover the interest rate risk exposure of the issue, which needs be conducted in future. This mainly helps the borrower to reduce the negative impact from changing interest rate, which might decrease the overall funds accumulated from Bond issue.
Moreover, investors also use future contracts to freeze the current prices of a particular share, for the time when surplus funds available to him. This adoption of future contracts may be allowed by the investors to reduce excess capital investments due to rising prices.
Defining future contracts and describing the basic principles behind use of futures to manage risk exposures
Leeson mainly used future contracts to increase its exposure in Nikkei futures and JGP futures, as he mainly thought that Japanese equities market would recover from the 30 week recession. This bold move was mainly instigated by Leeson to rely on the rising prices of Nikkei futures, which backfired due to an earthquake in the country (Yoon, Yildiz & Talluri, 2016).
The maintenance of adequate future contract needs different types of measures, which could be conducted by investors to buy the financial instrument (Drach?Zahavy, Goldblat & Maizel, 2015). There certain procedures that need to be followed by purchasing a future contract, these procedures are depicted as follows.
- Market order related to future contract will mail you be placed with a broker where the investor could buy or sell a particular contract.
- The future contracts are mainly traded with the help of an exchange and regulatory body.
- The transactions related to futures contract are mainly conducted with the help of open outcry on the exchange floor. Currently all the relevant exchanges use electronic trading platforms, which help in smoothing the buying process of future contracts. This feeling system automatically matches all these sell and buy orders to conduct transactions in future contract.
- The clearinghouses mainly guarantee the transactions, which are conducted with the help of margin and notation calls.
- In addition, initial margin is only paid for the future contract rather than the full contract price.
- Maintenance of margin calls is also essential by the clearinghouse for certain future contracts, which helps in identifying the overall gains or losses incurred from the exposure.
There are certain implications for investor who is long in future contract these implications are as follows.
- The investor that has taken a long position in the future contract is mainly exposed to all the losses and margin calls if prices of the future contract declines or falls.
- In addition, the investor having long position is mainly obligated to buy the underlying asset regardless of the declining prices (Capitani & Mattos, 2015).
- Regular maintenance of margin call needs to be conducted by the investor of future contract, which could help in fulfilling their requirements of the exchange.
There are certain implications for investors who are short in the future contract these implications are as follows.
- Investors that are selling the future contracts or short in the future contacts will mainly be exposed to the losses and margin calls if prices of the underlying asset increase.
- Investors that has short the future contract Emilia price to sell the asset, regardless of the rising prices in the market.
- The investor mainly needs to maintain the margin call within the exchange effectively trade in the market. Accumulation of losses more than the margin call could eventually of the investor out from the exposure and realise the losses (Simon & Campasano, 2014).
The relevant procedure that needs to be followed by the investor closing the overall position in the futures market before the delivery. These procedures are depicted as follows.
- The investor good mainly used the opposite contract effectively closing we open positions in future contracts. This could only be conducted before the delivery of the future contracts, when individual could take the opposite contract to obtain the gains made from an investment (Fallah & Ghaffari, 2015).
- For example if an investor Takes a long position in underlying asset, which is going to expire in few days. The investor daily needs to take a opposite position means a short position to nullify the contract and obtain then come from differentiated price. Majority of the investors mainly use this type of operations again from the price momentum and effectively increased profits.
- The similar case if a person has a short future contract then he needs to sell the commodity at a specified date. However, before expiry he could conduct a long future contract to nullify the contracts requirements and benefit from the spread. Thus, by taking opposite position before the expiry of the future contract investor is able to opt out of the trade before delivery of the contract (Stoll & Whaley, 2015).
Barings management also played a viable role in the overall scandal for not evaluating the actions of Nick leeson. Barings management was mainly astonished by the overall treats and achievements that were being projected by Nick leeson in recent years. Moreover, the management reduce control over operation in Singapore branch seeing the overall progress made by Leeson. In addition, there was low internal control over operations of Leeson conducted by the management (Reason, 2016). The management also lacked in producing independent risk management units for rechecking the activities of Leeson. The management of Barings Bank mainly had a thinly spread across the bank activities, which resulted in the unethical practices conducted by Nick leeson.
The management failed in three different levels, where it could control the overall activities of Nick leeson before accumulation of a massive debt. Managers of Barings mainly relied too much on Nick leeson for the activities in futures trade. The confidence portrayed by the management on the overall operations of Nick leeson mainly backfired, which resulted in use losses. The internal control system of Barings management was manipulative where Nick leeson was able to create a different account to hide all the Shady activities (Smith, 2013). Therefore, the management should have taken adequate steps in checking the operations and viability of the returns provided by Nick leeson before 1995.
This risk can be defined as a possible or probable occurrence of an unexpected activity that is not been anticipated and might increase uncertainty in business management. Depicting an explanation for the nature of risk, that is stated as follows.
- The business is mainly exposed to both financial and operational risk, which might hamper it, is over all activities and profitability (McNeil, Frey & Embrechts, 2015).
- Addition in the risk increases overall uncertainty in operations, which might hinder the forecasting process of an organisation.
- Operational risk mainly derived from did to the functions conducted in an organisation, whereas financial risk affects the overall cash flow, Assets and liability of the company.
The purpose of risk management is mainly depicted as follows.
- There is management many allows organisation to identify a risk associated with their business operations.
- Risk management also helps in identifying the overall risk outcomes, which might be conducted to from any business decisions.
- Risk management also helps in depicting all the relevant risk exposures, it could be measured managed and identified (Hopkin, 2017).
- This management also helps in reducing or mitigating both the operational and financial risk that could hamper activities of the business.
The railway authorities and regulatory bodies are mainly responsible for establishing the risk management objective policies and procedures of an organisation. The following persons are mainly responsible for delivering adequate risk management procedures.
- The board of directors are mainly responsible for documenting the entire risk objective, which might hamper operations of the overall organisation (Nguyen, 2014).
- After the documentation of all relevant to risk factors, the directors mainly determined to relate all the risk management policies and how it could be implemented to reduce any kind of negative impact in operations.
- The organisation meaning holds the executive management and the executive officer as the responsible person to establish risk management procedures, reporting structure and strategies. This could be helpful in reducing negative impact from operations.
- The directors are responsible for developing the overall procedures and strategies, which could help in imposing constraint and the rest and improve both management objectives and policies.
The evaluation of Nick leeson case mainly helped investor to identify the overall risk, which needs to be measured and managed, as it might negatively affect the overall investments. The major default in the case of Nick leeson was mainly because he was not able to comprehend and adapt to the changing risk attribute in futures market. Nick leeson was mainly taking wrong bets in Nikkei futures, which resulted in huge losses. In addition, Nick leeson for covering up the losses added new contract to cover the loss instead of closing his position (Kumari & Dinesha, 2015). This resulted in increased losses due to wrong position held by Nick leeson during the Japan earthquake.
Explaining the rules for setting risk management strategies
Therefore, analysing the case of Nick leeson, it is mandatory to identify, measure and manage the overall risk from investment before initiating any trades. If Nick leeson would have identified the overall risk, he would have understood the volatile geographical condition of Japan and how it could hit by an earthquake. This could have increased the overall risk from investment in Nikkei futures. Moreover, adequate measures could also be taken by Nick leeson when seeing 1000 points in losses over Nikkei futures. Thus, Nick leeson could effectively hedge its exposure and reduce any kind of unexpected risk, which might include from exposure and futures market. Hence, it could be said that using adequate measures for identifying and managing risk it effectively help investors reduce exponential losses in the capital market (Poledna, Bochmann & Thurner, 2016).
Capital could be identified as a primary cushion, which is needed by organisations to effectively conduct businesses in the competitive environment. Capital mainly supports operations of the company and deals with any kind of operating losses or unexpected losses, which might incur during the fiscal year. In case of Nick leeson, capital mainly played an adequate roll, as due to lack of adequate capital Leeson was not able to continue with its trading positions (Hans, 2015). Therefore, it is essential in the capital market to hold adequate capital, which might support activities and investor. Equity and Quasi equity capital is a source of long term funds fall the major institutions, which provide an adequate equity funding and help in growing the overall business.
Credit risk is mainly identified as the counterparty transactions, who can default on the commitments and does not repay the adequate sum. In addition, the minimum Capital requirement at the Basel II capital accord is mainly depicted as follows.
- The institution mainly requires a constant maintenance of risk capital ratio at 8% as the prudential standard requirements (Sutorova & Teply, 2014).
- Where bank could at least hold half of risk based capital ratio under Tier 1 capital and reminder capital may be held under Tier II capital.
- The regulator mainly requires the institution to maintain a minimum capital ratio of 8% and above for considering under Basel II capital accord (Sutorova, B., & Teply, 2013).
According to the example, if a bank provides a loan of 100,000 to a company with the credit rating of A. the overall capital required in the book value is (100,000 * 0.5 * 0.08 = 4000). Therefore, with the minimum amount of 4000 the bank could issue loan of 96,000. With the help of this measure in banks are able to adjust the minimum requirement capital for loan purposes.
The overall capital acceptable under the Basel II capital account is meaning the project as follows.
Tier 1 mainly states the core capital, which comprises of highest quality of capital elements, which Banks provides permanent and unrestricted commitment of funds, freely available to observe losses, imposing of any unavoidable service charges against any claims from depositors and creditors (Munk et al., 2013). Furthermore, Tier 1 capital also constitutes of the Bank minimum capital base. Basel II also comprises of Tier 2 components, where supplementary capital includes the elements of all the contributions hybrid capital instruments like equity and debt (Chalermchatvichien et al., 2014).
The overall capital acceptable under the Basel III capital account is meaning the project as follows.
Basel III has same component of Tier 1, where in Tier 2 it is divided into two parts. The Upper Tier 2 capital mainly comprises of permanent in nature that is hybrid capital instruments. In addition, lower Tier 2 capital comprises of instruments that are limited and have limited life instruments (Devereaux et al., 2013). Tier 1 comprises of ordinary shares, and retained earnings, whereas, Tier 2 capital comprises of convertible notes perpetual subordinated debt and lower Tier 2 capital depicts over subordinate is approved by regulator.
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