Nick Leeson Case
REVIEW QUESTIONS
1. Why did Nick Leeson sell numerous short straddles for each long futures contract he bought?
When Nick Leeson was being promoted on the Singapore branch of the Barings bank, the strategy of the bank was to reduce the risk exposure by using a combination of one short straddle (combination of put / call) and for one long future. Since Nick Leeson used to be a specialist on Future contracts on Nikkei 225 and Japanese 10 years bond and was sure this market would arise.
So he decided to sell disproportionate numbers of short straddles for each long futures position he took to pay the required initial margin deposits and new trades and also to meet the mounting margin calls on his existing futures positions, he used the cash the bank made from the sale of the short straddles.
2. Explain Nick Leeson’s doubling strategy.
On a bet, if you lose, you can then decide to double the bet. This way, if you win, you can get the same profit you could you win on the previous bet. The problem is that if you lose again, then you would have doubled your losses. So, for the profit you could win on the first bet, you double your losses on all the other bets you make and lose. At the end of the day, you can bet enormous amounts to just have a very small profit.
As an example, we can take the fair coin. On the first bet, you can bet $1. If you lose, then you have lost $1. So, on the second bet, in order to have the chance to do $1 profit, you need to bet $2 (you could get a profit of $2 on the second bet but you have made $1 loss on the first one). After like 5 time you lost, you should bet $16 to just get the chance to have 1$ profit:
For the bet: 1 x 2 x 2 x 2 x 2 = 16
Previous losses: 1 + 2 + 4 + 8 = 15
So you get $32 revenue but you have bet $16. So you earn $16 but you have lost $15 from previous losses. So at the end of the day, you got $1 profit for a $16 bet.
3. Has Nick Leeson drawn too much of the blame for what went wrong at Barings
1. Why did Nick Leeson sell numerous short straddles for each long futures contract he bought?
When Nick Leeson was being promoted on the Singapore branch of the Barings bank, the strategy of the bank was to reduce the risk exposure by using a combination of one short straddle (combination of put / call) and for one long future. Since Nick Leeson used to be a specialist on Future contracts on Nikkei 225 and Japanese 10 years bond and was sure this market would arise.
So he decided to sell disproportionate numbers of short straddles for each long futures position he took to pay the required initial margin deposits and new trades and also to meet the mounting margin calls on his existing futures positions, he used the cash the bank made from the sale of the short straddles.
2. Explain Nick Leeson’s doubling strategy.
On a bet, if you lose, you can then decide to double the bet. This way, if you win, you can get the same profit you could you win on the previous bet. The problem is that if you lose again, then you would have doubled your losses. So, for the profit you could win on the first bet, you double your losses on all the other bets you make and lose. At the end of the day, you can bet enormous amounts to just have a very small profit.
As an example, we can take the fair coin. On the first bet, you can bet $1. If you lose, then you have lost $1. So, on the second bet, in order to have the chance to do $1 profit, you need to bet $2 (you could get a profit of $2 on the second bet but you have made $1 loss on the first one). After like 5 time you lost, you should bet $16 to just get the chance to have 1$ profit:
For the bet: 1 x 2 x 2 x 2 x 2 = 16
Previous losses: 1 + 2 + 4 + 8 = 15
So you get $32 revenue but you have bet $16. So you earn $16 but you have lost $15 from previous losses. So at the end of the day, you got $1 profit for a $16 bet.
3. Has Nick Leeson drawn too much of the blame for what went wrong at Barings