Nick Leeson’s strategy to earn trading profits on derivatives?

Nick Leesons scheme to earn occupation boodle on derivatives?Originally, trader Nick Leeson was supposed to be exploiting low- chance arbitrage opportunities that would supplement price differences in similar equity derivatives on the capital of Singapore coin Exchange (SIMEX) and the Osaka Exchange. In fact, he make up a strategy to earn trading shekelss on derivatives where he would catch to bump off much put on the lineier positions by buying and selling different amounts of the contracts on the ii flips or buying and selling contracts of different types. Leeson was speculating wildly and completely with fall out authorization, in massive amounts on movements in the Japanese stock and bond commercialiseplaces.Leesons trading activities in the main involved three risings food markets Futures on the Japanese Nikkei 225 stock might, futures on 10-year Japanese Government bonds (JGB futures) and European futures. Leeson executed a trading strategy known as a run, wi th the objective of making a profit by selling put and call options on the same key pecuniary instrument, in this case, the Nikkei 225 Index. Most of his trading was a bet on the volatility of the capital of Japan stock and bond markets. In his futures positions, he was dissipated that the Tokyo stock market would rise and the bond market would fall. He was long Nikkei 225 futures, short Japanese regime bond futures, and short both(prenominal) put and call options on the Nikkei Index. He was betting that the Nikkei index would rise, even so he was wrong instead it fell, causing him to lose $1.39 billion.A straddle will generally produce positive earnings when markets argon fixed except can result in puffy losings if markets are volatile. He planned his strategy taking into consideration the Japanese futures market as in Japan the brim is blank spaceed on a net basis for all costumers and if thither are nodes who are in short position, faithful can blast long positio n without distributively need to pay the call margin. He utilized this opportunity through with(predicate) his phoney actus reus notice 88888 and companies account 99002.What went wrong that ca utilise his strategy to ruin?Leesons strategy failed because he was taking into consideration that the market hadexperienced an elongate bull run throughout the late 1980s and after that, it had locomote tohalf of its 1989 high. He thought that it had fallen enough and from now it would only(prenominal) go up, and he continued to bet that it would rise but the Nikkei 225 index only kept falling. Leeson further augmentd the size of his percipient positions even out as his losings ontogenesisd collectable to volatility in the markets. He did noaffair to hedge his position to lay off his potential losings if the markets did move the wrong way. In effect, Leeson was accepting unlimited li ability.The second thing that was that he was relying on the bank interest rate that it would d ecrease but eventually the exact reversal happened and the interest rate increased to a high. He thought if that the interest rates were low at the second gear and if they were going to rise they would hurt him as more of the investors would move towards serious earning through the high interest rate returns, making the investment into market to reduce and hence to make himself on the safer side he invested into government bonds futures.Nick Leesons doubling strategy failed because he increased the size of his open positions even as his losses increased due to volatility in the markets and kept doubling his contracts whilst the Nikkei 225 continue to plummet following an earthquake in Japan. However, Leesons unauthorized trading positions suffered huge losses, and his operation unraveled. Moreover, interest rates did not rise as he expected which introduce to further losses incurred on the Japanese government bond futures. He left the fanny with huge liabilities totaling $1.4 b illion, leading to the bankruptcy to the one of the oldest bank in Britain. wherefore did Nick Leeson establish a simulated error account (88888) when a licit account (99002) already existed?Nick Leeson set up a bogus error account (88888) even when a decriminalize account (99002) already existed, in order to conceal his unauthorized trading activities. Initially he claimed that he opened the error account (88888) to conceal a champion loss of 20,000 pounds sterling that had resulted from an accounting error until he could make up the difference through trading. However, he continued booking various losses into the error account (88888) as a holding area for any(prenominal) premiums or losses that he made and as well as continued to increase his volume of trading and level of risk taking. It was a loophole he ill-used to set up bogus accounts for non-existent clients to mask mounting debts.While the legitimate error account was known to exposes Securities in London, the bogu s account was not. However, the bogus account was known to SIMEX as a customer account, not as an error account. In this way, Leeson could hide his balances and losses from London but not Singapore. One the separate hand, SIMEX thought the bogus error account, 88888, was a legitimate customer account rather than a proprietary Barings account. The account enabled Leeson to take advantage of the rules of Japanese Futures market at that era. In Japan margin was posted on net basis for all customers. Therefore if many customers were short index futures, the firm could take long position without having to post cash margins.Why did Barings and its auditors not percolate that the error account was used by Leeson for unauthorized trading?The reason why Barings and its auditors did not discover Leesons unauthorized trading and fraudulent activities was mostly a lack of inbred checks and balances, and because Leeson was hiding in Barings organized chaos. Leeson was likewise given power due to his knowledge and in that respect was no inquiry through into his trading undecomposed because he reported a profit to the company. Barings was impressed by Leesons achievements which lead them not to disclose to SIMEX that he infact had been disqualified from taking the UK traders exam (Broady, Roland, Woods, 2008). gibe to Ron Baker, the Head of Financial Products Group for Barings, There were no clearly hardened down reporting lines with regard to Leeson, and in actual fact, on that point were some(prenominal) people answerable for keeping an eye on Leesons performance, but each one of them assumed that the other was watching closer than them, in that respectof allowing Leeson several(prenominal) holes to get through.An internal auditor audited the Singapore office of Barings in 1994 and he reported that unauthorized trading could grow happened because of the fundamental principle of the fabrication segregation of front and back office activities. The results were disclosed to the directors as intumesce as some of the auditors recommendations, but the directors did not implement these recommendations (Collier Agyei-Ampomah, 2006). Moreover, Leesons actions could have been avoided if the Barings executives had make a comprehensive review of Leesons funding requirements, as well as set restrictions to what Leeson could or could not do. However, he also discovered that none of these changes to the internal structure had been implemented when the bank collapsed.One of the main reasons why Leeson was able to get away with so much was that there was no clear segregation of duties (Broady, Roland, Woods, 2008). The nature of the Japanese futures market at the time did not require telephone exchanges to have a separation between the customer and the proprietary finances, which made it difficult to separate the funds and the position of the firm or customer.Leeson was left to be in control of everything that should have been suss out by a s uperior or coiffer of some other de component partment, which enabled him to track and modify the contents of his rogue account as he wished and keep his activities from being disclosed.Although the Director of BFS and the Finance Director of BSS, Simon Jones, pledged to the universe that he would attend to the issue of segregation, he never actually took any action to separate Leesons front and back office doings. The shore of England made a report on the matter and according to the report, the London of age(p) comement actually considered Jones to be an inadequate communicator, and were concerned with the fact that he was not as involved as he should have been in the affairs of BFS. Furthermore, the camber of London also criticized the process of Leesons funding.Firstly, credit checks should have been performed on the prodigious amounts of funds changing hands, but this was not performed either. Secondly, slang of London discovered that there was no clear record of whether the funds reported were needed for its clients, or for its own accounts. This made reconciliation to the highest degree impossible. The trading account was also not shown on any files or statements transmitted from Singapore to London, and and so auditors could not find any conception of the error account.Moreover, SIMEX reason the 88888 account as a customer account rather than an error account.Internally, Barings had raised issues about having proper reconciliation in 1992. The risk manager of Londons branch, Gordon Bowser, had brawnyly recommended a development of a red-blooded reconciliation process. However, Bowser left both others (Simon Jones and Tony Dickel) who had internal conflict over Leeson, to determine on the matter of reconciliation procedures, there was no solid transcription between the two and Leeson was left to create the procedures for himself, allowing him to dictate the way he managed things. The loss of reconciliation meant that auditors could not tr ace the nature of these funds and thus they were unable to uncover the error account that Leeson used for his tradings.Over the years, there were several cases of internal conflict which was beneficial to Leesons stealthy activities. A circumstance example of this was in 1995, where SIMEX became apprehensive about the ability of Barings to meet its large margins in Leesons error account. SIMEX addressed a letter to Simon Jones, with the letter noting that a further $100 million should have been in account 88888. sooner of addressing the matter himself directly, Jones passed the letter to Leeson for Leeson to draft a response on his own.Lastly, when Leesons activities were finally being caught on by SIMEX, but they had not managed to find out exactly what was happening, SIMEX posted another letter to the Singapore branch, expressing doubts about Barings ability to fun margin calls. The letter was then referred back to London and from there SIMEX was assured that opposite positions were being held in Japan. However, the equity was no opposite positions were being held and SIMEX officials made no follow-up checks with Osakas Stock Exchange to demonstrate the claims.Why did none of the regulatory authorities in Singapore, Japan, and the United estate not discover the true use of the error account?none of the regulatory bodies of Singapore, Japan on the UK discovered the true use of Leesons error account because firstly, it was visible to them only as a customer account, and SIMEX had also granted an exemption on the number of contracts that Barings could hold with the presumption that Barings was hedge and not speculating. This is in fact due to Barings conservative firm reputation, which lulled exchange and clearing houses into a false sense of security. Additionally, Barings speculative position was hole-and-corner(a) with the use of an omnibus account and with this account, the brokers customers identities could successfully be hidden from the exchange and clearing houses.A number of happenings in the UK also allowed Leeson to hide and manage his activities easier. At that time, the Bank of England had a rule known as the largish pictorial matter Rule which stated that a bank is unable to add together more than 25% of its capital to any single entity. Barings made a request to Bank of London for an exception and argued that one exchange should not be classified as one entity. The supervisor in take of Barings activities recognized the argument and the request and promised to review it and in the meantime, he offered Barings an unceremonious grant for Japan, which Barings extended to Singapore and Hong Kong. On the matter of the Large Exposure Rule, the supervisor failed to respond until one whole year later, and his answer was that there were no exceptions to be made and the positions taken under the informal concession should be unwound. By that time, the damage had already been done.The Bank of England also set up that f ollowing the consolidation of Baring Securities Ltd and Baring Brothers and Co., it allowed the two to be categorized as one entity for capital adequacy and large exposure purposes, but the process of this consolidation was too informal and the results of it played a part in Leesons unauthorized activities. This not only meant that Leeson could hide his activities, but also the fact that he had access to a much larger pot of capital.Why was Barings Bank willing to transfer large cash sums to Barings Futures Singapore?Barings Bank believed that the large cash sums transferred to Barings Futures Singapore was for loans to customers as portrayed on the Barings Futures Singapore balance sheet. The key aspect of Japanese Future market was that exchange did not require a separation between customer and propriety funds. Therefore it was impossible to distinguish between the firms and the customers position.Why did the onset by the Bank of England to organize a pledgeout for Barings fail ?Throughout that weekend, the Bank of England hosted meetings in London to try to form a consortium to bail out Barings. The attempt by the Bank of England to organize a bailout for Barings failed because no one would assume the contingent risk of additional, but as yet undiscovered losses. Bank of London made a huge sweat to organize a bailout for Barings bank. The bailout failed because Barings bank reached the position where losses amounted more than take over the capitalization of the bank, estimated losses approached $1.1 billion. Further losses were inevitable and thus there was no one ready to assume the contingent risk of additional but yet undiscovered losses. The bank was trapped in such a situation that the amount of future losses was secret and unrevealed due to the unauthorized dealing by Nick Leeson. project regulatory and instruction reforms that might prevent a future licking of the type that bankrupted Barings.There have been numerous cases of collapses and ove rwhelming losses to companies in the corporate and banking sector and this called for some serious reformation, with particular attention to derivatives. The constitutional sector did not sit up and take notice until the Baring Brothers bankruptcy. How could an entity steeped with trust and history fall apart with no signs? Following the bankruptcy, reports were created by the Bank of England, SIMEX, and the Group of xxx to suggest ways in which regulators and legislators could increase monitoring of financial activities.After the collapse of Barings Bank, an article was published with the name of Global Institutions, National Supervision and Systemic Risk, and this article underlines the reforms and changes in the financial sector that have already been implemented.The reforms that have already been implemented include the expanded usage of netting and collateral enhancements in methods to measure risk greater off-balance-sheet risk disclosure extensive increases in major financi al institutions equity capital, financial sector consolidation and encouragement of growth of securitization.The Bank of Englands report detailed how the losses occurred, the reason the losses were unnoticed in and out of Barings, and the lessons learnt from the bankruptcy. The following are the five lessons the Bank of England identified (Ambit ERisk, 2010) counseling teams have a duty to insure fully the worry that they manageResponsibility for each business activity has to be clearly open up and communicatedClear segregation of duties is fundamental to any effective control dodgeRelevant internal controls, including independent risk management, have to be established for all business activitiesTop management and the Audit Committee have to ensure that significant weaknesses, identified to them by internal audit or otherwise, are resolved quickly.The list that Bank of England came up with seemed simple, but the truth was one (or usually several) points listed were often the re ason why corporations lost large amounts of money in the derivatives market.Other ways in which to prevent future debacles like the Barings collapse would be an increase in supervision of employees. Leeson never had a trading license prior to his arrival to Singapore and there was scarce monitoring of his activities since no one person was directly responsible for supervising his trading activities (Burnett, 2006). Also, a clear reporting line should be enforced because Leesons fraud could have been facilitated by confusion in having two reporting lines one to London for proprietary trading and the other to Tokyo for customer trading.Top management should also be aware of the business that they are dealing with. In the case of Barings Bank, Leeson was reporting huge gain to the company but top management should have known that arbitraging is a relatively low risk and low profit business (Collier Agyei-Ampomah, 2006), so how on earth could Leeson have been reporting such massive c lams? Top management could have identified these flaws immediately if they had known and had they done their job properly (Narayanaswamy, 2008). It is thus very important for top management to have sufficient knowledge of the field (or be involved in) to understand the complexities of business and its fundamental concepts.Based in Washington DC, the Group of Thirty began to be particularly apprehensive of the risks that derivatives posed. The Group has issued numerous periodicals to address these problems, mainly numbers like International Insolvencies in the Financial Sector, Discussion Draft, which outlined 14 ideas to reduce risk in the financial sector, particularly with derivatives. Another publication titled International Insolvencies in the Financial Sector, Summary of Comments from Respondent Countries on Discussion Draft, which showed member countries responses and opinions regarding the proposed changes to financial institutions. It was noted that the support for these c hanges were generally strong among all the countries that responded, which showed how Barings failure rocked the entire worlds confidences in the financial sector.