To understand how this debacle came about, one must have a basic understanding of the nature of a derivative and what they are designed to do. Initially, derivatives were designed to provide an investor/trader with a type of insurance against unexpected movements in prices which could devastate an investment portfolio. These derivatives take the form of futures and options:
A future is an agreement for the future delivery of a certain commodity/
financial instrument at a price set at the time of the contract.
An option gives the purchaser the right, but not the obligation, to buy/sell
a certain quantity of a specific asset at a fixed price at, or before,
In this instance, Nick Leeson, a 28 year old trader at Barings Bank, made a bet that the Nikkei 225 would not drop below 19,000. During the morning of January 17, 1995, the city of Kobe, Japan was hit with a major earthquake. As a result, the Nikkei 225 plunged 7% in a week. Unbeknownst to senior management, Lesson had no hedge to protect the bank against an unexpected event such as this. The losses resulting from these transactions resulted in the loss of almost a billion dollars and wiped out the capital of Barings Bank. This event occurred through a mixture of corporate greed and a lack of internal controls.
One of the most unusual aspects of this case was the fact that Barings Bank allowed Nick Leeson to settle his own trades. At most banks, trading and settlement are handled by two people. Allowing one person to handle both sides of the transaction was a recipe for disaster: an unscrupulous trader, such as Leeson, has a way to...