Nick Leeson led to the bankrupting of the Barings bank in 1995. The Barings Bank was a well-known bank which financed the Louisiana Purchase, Erie Canal and the Napoleonic Wars. It was one of the oldest bank and served as the personal bank to Queen Elizabeth. Nick Leeson led to a financial scandal which led to a $1.4 Billion loss due to an engagement with unauthorized derivatives speculation leading to the end of the 233 year old bank (Bodie, 2013). Nick Leeson worked at some financial firms after graduating from University. He then joined Barings and was transferred to Indonesia where he was to sort out some back office issues which he succeeded in 10 months. This performance created such an impression and he was transferred to Baring securities in Singapore where he was promoted to a general manager. This responsibility involved having the ability to hire back office staff as well as traders. He took an exam in order to obtain the qualification he required to trade in the Singapore Mercantile Exchange. His responsibilities included transacting futures and options for clients of Barings, arbitraging price differences between the SIMEX and Japan’s Osaka exchange concerning the Nikkei futures. These methods would allow Leeson and other traders a lower level of profit compared to remarkable gains. Due to his position in the company, Leeson had the capacity to oversee back office functions as well as the trading department. This made it difficult for the required checks and balances that are often present in banks. In addition, the management of the Bank had a penchant to underestimate the risks involved during trading. This loophole made it possible for Leeson to engage in unauthorized speculation of the Nikkei stock index futures and the Japanese government bonds (Bolton & Wang, 2013). This meant that Leeson engaged in making direct directional trades on the market. Leeson opened up a secret trading account in which he engaged in the risky trading engagements. His speculative moves were not that good and he made quite a number of losses. Initially he lost 2 Million, which later became 23 Million and by the end of 1994, it became 208 Million. He however continued to engage in the trading activities for which he undertook a large position that included 85% of the open interest in the JGB and an open interest in the Nikkei future. This move was not advantageous since he went on to loss as the market continued to decline. The Earthquake that happened in Japan in 1995 further affected the Nikkei. Leeson decided to continuously purchase the Nikkei futures with the hope that despite the fact that the Nikkei was losing (Bodie, 2013), eventually it will have enormous gains. He therefore managed to fabricate profits which made him look like a good trader. Also, Leeson managed to hide his losses in that he lived a high roller life with high monthly earnings and securing bonuses from the trades. It has been argued that Leeson was a poor trader since he engaged in emotional trading compared to taking calculated risks. His activities were eventually uncovered and the financial debt in Baring Bank was discovered. He was then sent to trial and charged on fraudulent charges where he was sentenced to 6 years imprisonment. Baring Bank was liquidated by KPMG (Bekaert and Duca, 2013).
A futures contract is a legal agreement to buy or sell a financial instrument or commodity at a predetermined price in the future. Futures contracts are used by both hedgers and speculators. The producers of an underlying asset hedge set the price in which the commodity is sold while the portfolio managers make bets with regard to the price assets of the underlying asset using futures. For example in the event the price of oil in a year is 55 dollars per barrel, the producer can opt to produce the oil and sell it at the current market prices or he can instead chose to sell the oil at an expected future price. The mathematical model that prices futures takes into account the spot price, time to maturity storage costs, risk free rate, dividends and yields (Chance & Brooks, 2015). One the producer enters in this contract, he is obliged to deliver the oil whether or not the price is $55 per barrel or not. The buyers of the futures contract hold a long position while the sellers of the futures contract hold a short. The futures contract is facilitated by a recognized stock exchange which acts like a facilitator and mediator. The exchange therefore requires that the parties put forth a margin as part of the contract which is a nominal account. The futures prices are volatile hence the difference in price is recovered from the margin. Once the margin is used up, the buyer has to increase the value of the margin in a process referred to as marking to market. Regardless, it is the spot price which is used to decide on the difference with a disregard for the margin on the day of delivery (Hodrick, 2014).
Futures are used to hedge against risk or speculate prices more so since they have finite lives. They can therefore be used for mitigating financial risk as a result of price fluctuation by taking advantage of the price movements instead of buying and selling of the cash commodity. The commodity is therefore delivered within a stated month in the future unless the contract is terminated before it expires (Hamilton & Wu, 2015). The price fluctuations create the profits and losses for the trader. In the case of futures, individuals who aim to arbitrage look at the relationship between the cash and futures in order to exploit their mispricing’s. For example, in case the arbitrageur realizes that the gold futures were overpriced compared to the gold market prices and the interest rates, he would therefore engage in a long due to the risk free profits that could accrue. On the other hand the traders on the floor would react by pushing down the futures price and align it with the cash market. While the futures are traded by the commodities futures exchange, they are owned by the CME group and regulated by the Commodities Futures Trading Commission which requires that all buyers and sellers register with them (Reason, 2016).
According to the basic rule of setting up a risk management strategy, the trader should aim to carry out a transaction in the futures market which matches with what once can do in the later date of the physical market. In the event that a borrower wants to raise funds, it will therefore sell its future contracts in the current date in order to take care of the interest rate risk exposure when it eventually issues the paper. In the case an investor wants to purchase shares when the funds become available and is concerned with the level of share price in the future, the investor may purchase the future contracts today while the open position will be closed when the actual shares are purchased by the following futures contract (Saunders & Cornett, 2014).
In the case of Nick Leeson, it was necessary that the futures contract he engaged in had the potential of performing in a similar manner to the current market reactions. Nick Leeson did not account for this level of risk and therefore the performance of the futures contracts he undertook and the market performance. This high level of deviation led to massive losses in his trading strategy (Stoll & Whaley, 2015).
First, the futures contract is traded on the formal exchanges such as the Chicago futures exchange. Next, the market order is placed by a broker in order to purchase or make a sale on the futures contract. The buy and sell transactions are made through an open outcry on either the electronic trading platform which is most commonly used today or manually on the exchange floor. The electronic system uses an algorithm which automatically matches the market orders. The clearing house of the exchange records the details of the transactions and it guarantees the validity of the transactions through margin calls and novation processes. A novation is the agreement in which a party in the contract is replaced by another through the aspect of transferability. The initial margin is therefore paid without the full futures contract price. The margin should be adequate to cover the movements in contract prices in the event it becomes necessary to close out the position for a client. It is the role of the clearing house to match the market prices each day. The maintenance margin calls are required by the clearing house that needs the broker to increase the margin levels especially when the contract price has moved so low and the initial margin which was put forth was no longer sufficient. The trader who has a long position has a high risk of losses and margin calls in the case the price of the underlying asset falls.
In the case a trader has a short position in a future contract, it means that the trader has sold the futures contract. In the event the prices increase, the trader will be exposed to margin calls and losses. Losses since the prices are higher than initially purchased and margin calls since the initial margin may prove inadequate to deal with the price fluctuations adequately (Reason, 2016).
First, the open futures are closed out by the client before the delivery date through the undertaking of an opposite contract. A long happens when the trader buys a futures contract. The party in the long position will close out the open position through the sale of another futures contract of the same asset and delivery date. The short position happens through the purchase of a futures contract of the same asset and delivery line which should be closed out.
There are three main factors which determine the collapse of Barings Bank which included the use of bureaucratic structures in providing oversight to the futures contracts, the risks available to the parties undertaking the transactions and the benefits which were to accrue to the parties involved. In as much as the organization liaised with the government to oversee the derivatives market, the bureaucracies involved are inadequate to mitigate the risks involved. Bureaucracy mostly involved division of labor which allows for specialization and the efficient development and allocation of functions. However, when the organization is large enough, oversight becomes difficult despite the existence of middle management. Barings therefore failed by giving Leeson the authority in engaging in a number of trades meant to benefit the firm. In addition, he was also privy to information that could allow him to manipulate the transactions as he required. Despite the fact that the London and Singapore offices were meant to oversee his activities, the various levels of management present were ineffective. There was a collapse in the organizational structure in which Leeson was scrutinized by more than one person and therefore they could not provide sufficient oversight. In addition to the poor organizational structure, Leeson and the bank staff had lack of respect for the internal controls which failed to detect and prevent his unauthorized trades (Stoll & Whaley, 2015). In addition the firm failed to effectively delegate duties which increased the risk and occurrence of collusion especially when more than one responsibility is given to one individual. Leeson was given the responsibility to trade as well as to clear. This conflict created sufficient room for Leeson to manipulate the books for a long time without being uncovered. In this case lack of managerial oversight contributed a big portion of the mismanagement of the trading strategies by Leeson in Baring Bank.
Risk in the general sense is the change of gaining or losing something of value. In the financial sense risk encompasses a variety of issues which may affect the position of a trader or client while engaging in the financial transaction. There are a number of risks in the financial market. There are risks inherent to the immediate parties involved and the risks to third parties involved. Overestimation and underestimation of risk are equally dangerous since they lead to either loss of a profitable opportunity or the loss of financial value. A market risk comes from the potential of financial loss due to interest and currency rate movements. In the case of Leeson, he thought that the interest rates would decline while they did not leading to further losses. Hedging is the appropriate way of insulating against the market risk as the banks that buy the derivatives reduce the risk exposure of the client. Leeson acted in a speculative manner which made his transactions quite unhedged (Reason, 2016). In addition, there was legal risk that arose from the potential of a regulatory body to invalidate a derivative contract. A court of any other regulatory body may have found an illegality in the contracts which were engaged by the bank which may lead to financial loss. In order to manage legal risk, the parties involved should have sufficient understanding concerning the issues with regard to the enforceability of the contracts. In the case of Baring Bank, the Deutsche bank sued the company for entering in a swap despite the knowledge that it had no funds to do so. The legal risks to debtors often increase the risk to bankruptcy of a company as was the case in Barings company. The other type of risk experienced by the company was credit risk which involved a financial loss experienced as a result of the company being unable to meet its financial obligations. In the case of Barings, the credit risk was quite low since its margin deposits covered the losses. The company also suffered from operations risk exposure due to inadequate systems, faulty controls and management’s failure. The failure of Baring’s management to monitor derivative transactions contributed to its downfall since there was a high operations risk. In addition there were also risks posed on third parties such as a country’s economy. Since the foul practice was mainly done by one person, the events of baring company did not quite harm the economy of any country but it had the potential to.
Concerning all forms of risk, it is the role of management to instigate proper measures and mitigation procedures which can protect the firm and its finances from the adverse risks. The management should therefore actively take up a monitoring role in their approach to risk as much as identification and management of risk is concerned. It is important that the management identifies all the risks concerning the business in order to effectively manage them. There also needs to be stringent internal control measures such as segregation of duties, oversight and approval measures that can reduce the risk potential of the business (Bodie, 2013).
Capital includes the resources that aim to increase the productivity or wealth of an economic activity. One of the functions of capital is to provide equity funds for a corporation to finance expansion and production activities. It also provides equity funding for growth purposes. It demonstrates shareholder commitment to the company and it also enables the company write off periodic losses of defaulting borrowers that exceeds profits (Hodrick, 2014).
The Basel II is a set of banking regulations set forth by the Basel Committee on Bank Supervision. It incorporates credit risk that determines the capital adequacy of banks. It therefore uses the credit risk of assets in the determination of regulatory capital ratios. It defines regulatory capital and provides a 8% minimum coefficient for regulatory capital using the organizations assets. Tier one consider shareholders equity, disclosed reserves, retained earnings and other capital instruments while tier 2 considers subordinated loans. Basel II also defines the risk weighted assets in that a higher weight reveals the riskiness of the asset. It therefore takes into account of the credit rating of the assets in determining credit risk. It therefore aims to provide regulatory supervision and stimulate market discipline with regard to the various types of risks (Hamilton & Wu, 2015).
References
Bekaert, G., Hoerova, M., & Duca, M. L. (2013). Risk, uncertainty and monetary policy. Journal of Monetary Economics, 60(7), 771-788.
Bodie, Z. (2013). Investments. McGraw-Hill.
Bolton, P., Chen, H., & Wang, N. (2013). Market timing, investment, and risk management. Journal of Financial Economics, 109(1), 40-62.
Chance, D. M., & Brooks, R. (2015). Introduction to derivatives and risk management. Cengage Learning.
Hamilton, J. D., & Wu, J. C. (2015). Effects of Index?Fund Investing On Commodity Futures Prices. International Economic Review, 56(1), 187-205.
Hodrick, R. (2014). The empirical evidence on the efficiency of forward and futures foreign exchange markets (Vol. 24). Routledge.
Reason, J. (2016). Managing the risks of organizational accidents. Routledge.
Saunders, A., & Cornett, M. M. (2014). Financial institutions management. McGraw-Hill Education,.
Stoll, H. R., & Whaley, R. E. (2015). Commodity index investing and commodity futures prices.
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