Trading strategy of nick leeson

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Trading strategy of nick leesonPhoto by David Cantwell (davidcantwellphotography)

Welcome to the official website of Nick Leeson the original Rogue Trader whose unchecked risk-taking caused the biggest financial scandal of the 20th century.

The collapse of Barings personal bank to HM The Queen in 1995 and Nick Leeson's role in it, is one of the most spectacular debacles in modern financial history. How could one trader bring down the banking empire that had funded the Napoleonic Wars?

Curiosity, intrigue and sympathy have been the various reactions to this man's incredible life story. Following Barings' collapse, Nick Leeson was sentenced to six and half years in a gang-ridden Singaporean jail, in conditions that defy belief, while at the same time, his wife left him and he was diagnosed with colon cancer.

Against all odds, Nick Leeson survived and now fully recovered from cancer, lives happily in Ireland with second wife Leona and three children. In 2006 Nick was appointed CEO of Galway United FC. Having stepped down as CEO in January 2011, Nick Leeson continues to be in-demand around the world for conference and after-dinner speaking.

Analysing Nick Leesons trading strategy in the market

There are three futures market which was occupied in Leeson's trading activities. There are Futures on the Japanese Nikkei 255 stock index, futures on 10 year Japanese Government bonds (JGB futures) and Euroyen futures. These products are traded and alike design on SIMEX and on a Japanese exchange. Leeson's main assignment was to arbitrage between SIMEX and the exchange in Japan and try to capitalize on low price differences between the futures contracts. Leeson was taking huge uncertain positions, financing SIMEX margin requirements by selling options and borrowing huge amounts of money from Barings's head office in London. By the end of February 1995, the losses had become too large and Barings bank went bankrupt.

Base on our research, the doubling strategies are potentially high risk from a systemic point of view which was Mr Leeson using it. The most important attribute of doubling strategies is that the inevitable and devastating loss is proceeding by a period if high return with low volatility. This doubling strategy was taking high risk.

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On July 1992, Barings Futures Singapore started trading on the Singapore International Monetary Exchange (SIMEX). Mr. Leeson was putting in charge of operations for Barings futures Singapore, with responsibilities for both trading and the accounting and settlements activities. Barings Futures Singapore believed that was unnecessary to segregate these functions because Leeson and his staff would merely execute orders placed by other Baring Group companies on behalf of their external clients (SR 3.1,5.15). Later in 1992 this situation is changed, because many of Japanese institutional investors had set up their own execution capability in Singapore. We know that BSJ traders ask Leeson to execute Nikkei Futures trades on SIMEX (SR 2.11) and the trading volume handled by Leeson was increased time by time in early 1993. Besides, Leeson was involved in executing proprietary trades as well as trades for the external clients of the Barings Group.

Leeson would play a major role for example arbitrage trading if the Nikkei futures contract between SIMEX and the OSE (Osaka Securities Exchange). We know there are existed larger price difference between the two contracts that were similar in design. The profit from exploiting like price differences between exchanges are small and therefore trading volumes tend to be large but the risk still low. Leeson also developed lucrative activity and name it as switching. When the Barings able to trade in Japan as well as in Singapore, it could select the cheapest market to execute a client's order. For the result, these activities was that the Structured Products Group, which includes Leeson's activities. showed an operating profit over 1994 which was five times what had been planned for that year.

On July 3 1992, only two days after Barings was granted membership by SIMEX, Leeson opened Account 88888 and that same day, the first transaction was booked in this account ( SR 3.13). On BFS's (Barings Futures Singapore) system, this account described as an error account. It is common for traders to set up such an account for the purpose of netting minor mistakes but the net position should be closed each day and net value of gain and losses incurred in negating the position should be recorded as part of unit's daily profit (Leeson,1996, p38-39). During the first month of its existence, a huge number of transactions were booked in Account 88888, which present according to the Singapore report (SR3.13) that it could never have been intended to serve uniquely as an error account. In fact, Leeson gave definitely instructions around July 8, 1992, to change the software to exclude Account 88888 from all market activity reports and the information was one and only used for the estimation of SIMEX's margin. In other words, the steps taken by Leeson in the first days of responsibility for activities of BFS, were to ensure that his actions would not be transparent.

During 1993, the focus of Leeson's unauthorized speculative positions in Account 88888 was the generation of profits in the normal trading accounts of BSL, and BSJ for the client or proprietary traders. This enabled Leeson to achieve a reputation as a star trader on SIMEX and enhanced his intrafirm executive standing. However, by the end of 1993 the cumulative losses in Account 88888 were over A?4 billion (about US$35.8 million) which made the situation much more intricacy. Leeson's main problem became the management of the flow of funds to support the margin calls from SIMEX.

An important way to plan the funding was by manipulating the trading and accounting records. This was done in a number of ways. First, some transaction booked in Account 88888 was initially booked in the accounts of BSJ and BSL. If these situations had been correctly reported to BSJ and BSL, it would have been clear that risk limits had been exceeded since such transactions were not hedged. However, Leeson would execute offsetting trades about thirty seconds before market close. Nick Leeson trying place transactions from BSL or BSJ accounts into Account 88888. This called transfer trade, Leeson avoided reveal of unhedged position in the reports to BSJ and BSL ( SR3.21). The price of these transfer trades were later adjusted to favor BSL or BSJ, at the expense of Account 88888,in order to confirm his reputation as an exceptional trader. A second way to handle the records was to record fictitious trades between the account of BSL and BSJ and Account 88888 in the BFS daily list of transactions, when no transfer trades had been executed. The effect was that unhedged condition were transferred from BSJ or BSL accounts to Account 88888, so that no unhedged condition were reported at the end of the day (SR 3.31). At last, Leeson often instructed his settlements staff to record fictitious trades in the accounting system. These fictitious trades reversed at the opening of market on the following day. The aim was to reduce end-of-day open positions in Nikkei and JGB futures in BFS's accounting records and consequently in the SIMEX computer system. This practice effectively decreased margin calls from SIMEX (SR3.37)

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Nick Leesons strategy to earn trading profits on derivatives?

Originally, trader Nick Leeson was supposed to be exploiting low-risk arbitrage opportunities that would leverage price differences in similar equity derivatives on the Singapore Money Exchange (SIMEX) and the Osaka Exchange. In fact, he made up a strategy to earn trading profits on derivatives where he would have to take much riskier positions by buying and selling different amounts of the contracts on the two exchanges or buying and selling contracts of different types. Leeson was speculating wildly and completely without authorization, in massive amounts on movements in the Japanese stock and bond markets.

Leeson's trading activities mainly involved three futures markets: Futures on the Japanese Nikkei 225 stock index, futures on 10-year Japanese Government bonds (JGB futures) and European futures. Leeson executed a trading strategy known as a straddle, with the objective of making a profit by selling put and call options on the same underlying financial instrument, in this case, the Nikkei 225 Index. Most of his trading was a bet on the volatility of the Tokyo stock and bond markets. In his futures positions, he was betting that the Tokyo stock market would rise and the bond market would fall. He was long Nikkei 225 futures, short Japanese government bond futures, and short both put and call options on the Nikkei Index. He was betting that the Nikkei index would rise, but he was wrong; instead it fell, causing him to lose $1.39 billion.

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A straddle will generally produce positive earnings when markets are stable but can result in large losses if markets are volatile. He planned his strategy taking into consideration the Japanese futures market as in Japan the margin is posted on a net basis for all costumers and if there are customers who are in short position, firm can take long position without any need to pay the call margin. He utilized this opportunity through his bogus error account 88888 and companies account 99002.

What went wrong that caused his strategy to fail?

Leeson's strategy failed because he was taking into consideration that the market had

experienced an extended bull run throughout the late 1980's and after that, it had fallen to

half of its 1989 high. He thought that it had fallen enough and from now it would

only go up, and he continued to bet that it would rise; but the Nikkei 225 index only kept falling. Leeson further increased the size of his open positions even as his losses increased due to volatility in the markets. He did nothing to hedge his position to lay off his potential losses if the markets did move the wrong way. In effect, Leeson was accepting unlimited liability.

The second thing that was that he was relying on the bank interest rate; that it would decrease but eventually the exact opposite happened and the interest rate increased to a high. He thought if that the interest rates were low at the moment and if they were going to rise they would hurt him as more of the investors would move towards safe 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 Leeson's 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, Leeson's unauthorized trading positions suffered huge losses, and his operation unraveled. Moreover, interest rates did not rise as he expected which lead to further losses incurred on the Japanese government bond futures. He left the behind with huge liabilities totaling $1.4 billion, leading to the bankruptcy to the one of the oldest bank in Britain.

Why did Nick Leeson establish a bogus error account (88888) when a legitimate account (99002) already existed?

Nick Leeson established a bogus error account (88888) even when a legitimate 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 single 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 premiums or losses that he made and also continued to increase his volume of trading and level of risk taking. It was a loophole he exploited to set up bogus accounts for non-existent clients to mask mounting debts.

While the legitimate error account was known to Barings Securities in London, the bogus 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 other 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 time. 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 discover that the error account was used by Leeson for unauthorized trading?

The reason why Barings and its auditors did not discover Leeson's unauthorized trading and fraudulent activities was mostly a lack of internal checks and balances, and because Leeson was hiding in Barings' organized chaos. Leeson was also given power due to his knowledge and there was no inquiry done into his trading just because he reported a profit to the company. Barings' was impressed by Leeson's achievements which lead them not to disclose to SIMEX that he infact had been disqualified from taking the UK trader's exam (Broady, Roland, Woods, 2008).

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