Price Of Nikkei Futures Contracts example essay topic

Introduction In this case report, firstly, the arbitrage opportunities in the authorized trading which was supposed to exploited by Leeson and Lesson's trading strategy will be focused on. Secondly, our interest is to find out the strategy on how to lose more money than Leeson did. As the more we know how to lose money, the more effective control for the investment we realize. In addition, the loose internal management in Barings Bank was also a critical reason for the collapse of Barings and lessons from that is worth discussing and referring by the present financial institute. 1. Arbitrage opportunities in trades 1.1 Arbitrage opportunities between Osaka and Singapore Nick Leeson was appointed to trade derivatives on the Singapore International Monetary Exchange (SIMEX) and the Osaka exchange, and hence was making a low-risk profit, known as "switching".

Obviously, arbitrage opportunities existed in trading Nikkei future contracts in the two markets, when there is different price and it is easy to make profit by purchasing future contract in the market with higher price and selling it in the market with relatively lower price. For example, as shown in the Table 1, on 1st, November 1994, the price difference between SIMEX and OSX is 55, meaning profit can be realized by longing the Dec 94 future contracts in OSX and shorting it in SIMEX. 1.2 Arbitrage opportunities in future contract between Nikkei 225 spot and Nikkei 225 future Another arbitrage opportunity appeared in the Nikkei 225 futures and Nikkei 225 spot. Firstly, assume that there is no transaction costs, the dividends are received on a continuous basis, and that the nearest Euro-yen futures rate approximates the Japanese short-term free-risk rate and the FFP of Nikkei futures contract was calculated by (results are stated in the table 1) FFP = Step [ (r-D) ^o] Assume that there is no transaction costs, the dividends are received on a continuous basis, and that the nearest Euro-yen futures rate approximates the Japanese short-term free-risk rate. Where St = spot price of Nikkei 225 index r = riskless interest rate, D = dividend, a continuous 1% dividend yield on the Nikkei 225 ^o = fraction of a year from now to maturity. Here suppose the third Friday of exercise months as the expiration dates, which are 16 Dec 94, 17 Mar 95, 16 Jun 95.

On one hand, when the actual futures price is higher than the fair value of the futures, we can gain by purchasing the spot assets and shorting the future contract. On the other hand, and when the actual futures price is lower than the fair value of the futures, the trading will be profitable by taking a long position in future contract and selling the spot assets. 1.3 Arbitrage opportunities between implied interest and riskless interest In addition, the arbitrage opportunities can also be found by comparing the implied interest rate and the riskless rate. IRt = LN (Ft / St) /^o+q Where Ft = actual futures price; S = price of the spot assets; q = dividend rate: 1%; ^o = (T-t) /365 = fraction of a year from time t to T. As stated in the material, if IR r, borrowing at the riskless rate and lending at the implied interest rate of the futures contract; if IRO, Then 0.5 P (T-1), else 2 P (T-1) Refer to the material, the reverse of Double-up trading rules based on the previous prices to adjust position, can be used to lose money in Nikkei 225 futures more than Leeson over January and February 1995. When the closing price of the future exceeds the last day closing prices, reduces the position to 1/2 as much as currently held; when the closing price of the future is less than the previous day closing prices, doubles the position. That is, if you are holding 10000 positions of Mar 1995 contracts in the Nikkei 225 on 16th, January 1995 and the closing price is 19435 which is 120 more than the closing price on 17th, January, cut down the position to 5000 as illustrated in Table 3.3.

2 Losing strategy - Strip Here taking the Jun 95 option on the Nikkei 225 future contracts as an example to illustrate the losing strategy over the first two months of 1995. Firstly, calculation of the fair prices of listed options is the foundation stone. By HULL's software and the data from table 3 and 4 on handout, the current levels of implied volatility of the two months' historical volatility as shown graphically below Graph 1, from 10th October 1994 to 12th September 1994. Clearly, the implied volatility, 0.0936, of OSX (JUN) option had a significant difference to the mean of historical volatility, 0.1140, of the OSX (JUN), which was consistent with the simple rule that when the relative implied volatility is lower than the average, the option is effectively under priced. Selling the undervalued options provides a high potential of losing in the following two months. Secondly, the loss also rests with the price movement of the underlying asset, i.e. OSX (JUN).

A normal trader makes a personal expectation, with empirical and academic analysis basis on the historical market performance and technical indicators, that the OSX futures market would be a bearish one. Basically, if betting that there would be a profitable underlying asset price movement, the trader considers a decrease in the asset price is more likely than an increase so that he probably to make a profit by purchasing a strip. For a loser with the similar expectation, inversely, he writes a strip, i.e. selling two put options and selling one call option of the SIMEX (JUN) option, which is under the assumption that the position in the futures contract was closed out immediately at the time the option was exercised. The result of the deal goes as follow. Profit from OSX (Jun 95) Exercise Price = 19000, Call Price = 1074.55 Put Price = 154.55 Range of Stock Price Profit from call Profit from Put Total Profit St = 19000 20383.65-St 309.1 20692.75-St Using the formula, when the price of OSX-NIKKEI futures (MAR) moved to 17000 on the 28th February 1995, the negative profit of -2616.35 (2 17000-36616.35) is experienced. So the loser suffers a 2616.35 loss in the period by writing an OSX (JUN).

(Refer to Guang zhen Sheng's) 3.3 Fooling activities a. Fool the supervisors within the bank and the auditors Try to use more complicated financial instruments with compound trading strategies, in order to let as few as persons as you can, including the managers to understand what you are really doing. Make sure you are the only expert of the areas in your company or team and make up you authority among your colleagues or team members. Just show them the P&L and other reports in which you can adjust all the numbers to what they should be.

Try to build up a tight relationship and friendship with all the key persons in each link, which will influence the implementation of your trading strategy. The accounting or financial report department is necessary to help you manipulate the financial statements. So either you yourself be a man in these departments or you should have the leadership of them. b. Area Differences Local regulators do not always have the same criteria as the parent authority, and they can not understand or agree with every aspect of the methodology of regulation. So compare with all the details and discover that exits in the host authority but not in the parent authority, vice versa.

Then you can make explanations easily to both sides, especial to the parent side that your unconventional or abnormal operations were due to the host authority. (Refer to Sheng zhang Jiang's) 4. The lessons from Barings case It was Leeson, once recognized as a "star trader", furtively created a "error" account 88888 into which he put his lost of unauthorized trading transactions between SIMEX and OSE. Consequently, the account was run up to lose at $1.3 billion dollars and that eventually broke down the Barings as it could not sustain huge amount of margin calls. But Barings could not totally escape blame. Since the senior management allowed Leeson to control both the investment department and settlement department in BFS, as a result, he was able to conceal his unauthorized trading activities for over a year without detection.

Even when the price of Nikkei futures contracts kept falling sharply, the bank placed too much reliance on Leeson and still wired him $1 billion to continue his trading. If the Bank implements well-divided job allocation, and the entire employee take seriously of their responsibility and report to the senior management systematically and authentically. Simultaneously, a series of integrated supervision function should be adopted to audit and regulate the whole operations of the internal management. For example, the bank should set up an independent group of auditors to check the balance sheet issued by the accounting department regularly and also, the members of that group should be substituted after a certain period. Besides, financial derivatives constitute an important part of portfolio executed in banks, financial institutes and Security companies, it is necessary for the management to understand the operations of all the instrument. And also the risk-control measures should be set up for all the trading activities, for example, the limits of the open interest, the limits for the arbitrage activities, exposure rules and so on.

Finally, the Bank should develop extensive investment portfolio to distract risk. Conclusion The main conclusion in British report is pointed to failure of management to understand and detect activities being conducted within the group: The collapse was brought about by the unauthorized trading activities within BFS-one overseas subsidiary within a large group but whose activities accumulated losses of around 830 million pounds and caused the ultimate parent company, Barings plc, to be placed in administration. The collapse of Barings is an illustration of how a viable and prosperous group can, in circumstances where controls are ineffective, be brought down by unauthorized activities within one of its subsidiary operations. From the case of Barings, we can realize how important for the parent company to understand and control the operations of its subsidiary company.