How Leeson Broke Barings part 2
But Leeson's Osaka position, which was public knowledge since the OSE publishes weekly data, reflected only half of his sanctioned trades. If Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX. Why? Because Leeson's official trading strategy was to take advantage
of temporary price differences between the SIMEX and OSE Nikkei 225 contracts. This arbitrage, which Barings called 'switching', required Leeson to buy the cheaper contract and to sell simultaneously the more expensive one, reversing the trade when the price difference had narrowed or disappeared. This kind of arbitrage activity has little market risk because positions are always matched.
But Leeson was not short on SIMEX, infact he was long approximately the number of contracts he was supposed to be short. These were unauthorised trades which he hid in an account named Error
Account 88888. He also used this account to execute all his unauthorised trades in Japanese Government Bond and Euroyen futures and Nikkei 225 options: together these trades were so large that they ultimately broke Barings. Table 10.1 gives a snapshot of Leeson's unauthorised trades versus the trades that he reported.
For the rest of the chapter, contracts will be discussed or converted into SIMEX contract sizes.
Unreported positions (Fact)
The most striking point of Table 10.1 is the fact that Leeson sold 70,892 Nikkei 225 options worth about $7 billion without the knowledge of Barings London. His activity peaked in November and December
1994 when in those two months alone,
| Table 10.1 | Fantasy versus Fact: Leeson's Positions as at End February 1995. | ||
|---|---|---|---|
| Number of contracts1 nominal value in US$ amounts |
Actual position in terms of open interest of relevant contract2 | ||
| Reported3 | Actual4 | ||
| Futures | |||
| Nikkei 225 | 30112 $2809 million |
long 61039 $7000 million |
49% of March 1995 contract and 24% of June 1995 contract. |
| JGB | 15940 $8980 million |
short 28034 $19650 million |
85% of March 1995 contract and 88% of June 1995 contract. |
| Euroyen | 601 $26.5 million |
short 6845 $350 million |
5% of June 1995 contract, 1% of September 1995 contract and 1% of December 1995 contract. |
| Options | |||
| Nikkei 225 | Nil | 37925 calls $3580 million 32967 puts $3100 million |
|
| 1. Expressed in terms of SIMEX contract sizes which are half the size of those of the OSE and the TSE. For Euroyen, SIMEX and TIFFE contracts are of similar size. 2. Open interest figures for each contract month of each listed contract. For the Nikkei 225, JGB and Euroyen contracts, the contract months are March, June, September and December. 3. Leeson's reported futures positions were supposedly matched because they were part of Barings' switching activity, i.e. the number of contracts on either the Osaka Stock Exchange, the Singapore International Monetary Exchange or the Tokyo Stock Exchange. 4. The actual positions refer to those unauthorized trades held in error account '8888'. Source: The Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Commons, Her Majesty's Stationery Office, 1995 |
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he sold 34, 400 options. In industry parlance, Leeson sold straddles. i.e. he sold put and
call options
with the same strikes and maturities. Leeson earned premium income from selling well over 37,000 straddles over a fourteen month period. Such trades are very profitable provided
the Nikkei 225 is
trading at the options' strike on expiry date since both the puts and calls would expire worthless. The seller then enjoys the full premium earned from selling the options. (see Fig 10.2 for a graphical presentation of the profit and loss profile of a straddle.) If the Nikkei is trading near the options' strike
on expiry, it could still be profitable because the earned premium more than offsets the small loss experienced on either the call (if the Tokyo market had risen) or the put (if the Nikkei had fallen.).
Figure 10.2 Payoff Profile of a Straddle.