Derivatives Abuse
Options can be bad for your wealth if they lead to
gambling, where, by defini¬tion, the odds are
stacked against you, as distinct from the calculated
risks of speculation.
The scandals are few but big. There is no doubt that
determined individuals can always find a way to abuse
derivatives. It is by now well documented how trader
Nick Leeson took huge risks on derivatives and brought
down Barings, the investment bank where he worked.
Leeson was the star trader and general manager in
the bank’s Singapore office and, as it turned
out, he was inadequately supervised. The 28-year-old’s
trading strategy was based on arbitrage, which was
to profit from price differentials between the same
strategies on different markets.
In January 1995, Leeson started writing Put and Call
options on the Nikkei 225 index at the same exercise
price. It created a straddle and Barings would keep
the premiums only if the index stayed within the 19,000-21,000
trading range. Chance dictated otherwise and, when
on 17 January Kobe and Osaka were hit by a huge earthquake,
the Nikkei 225 fell too far. On 23 January, it had
dipped to 17,950.
Leeson started buying March and June 95 futures contracts,
which were a bet on an improvement in the market.
It was another gamble that went wrong. The Nikkei
225 deteriorated further, and eventually Barings had
lost more than £800 million, which was more
than its capital, and in 1995, it collapsed.
The event triggered consideration of the Bank of England’s
role of supervising banks, which was later transferred
to the Financial Services Authority. The Bank has
retained responsibility for the stability of the banking
system.
It is such events that have led to a public perception,
fuelled by the media, that derivatives are dangerous.
Warren Buffett, considered the world’s greatest
stock market investor, has called derivatives ‘weapons
of mass destruction’. City professionals unsurprisingly
take a more lenient view and note that hedging through
derivatives reduces rather than creates risk.
