Kapil AgrawalPLAYERS IN A

DERIVATIVE MARKET

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Derivative contracts are bought and sold by a large number of individuals, institutions and others for a variety of purposes.

Players in the derivative market can be categorized on basis of the PURPOSE for which they deal in the market.

Usually, derivatives attract the following type of traders: Hedgers, Speculators, Arbitrageurs and Spreaders.

PLAYERS IN A DERIVATIVE MARKET

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Hedge is a position taken in derivative exchange / markets for the purpose of reducing risk. A person who takes such position is called a HEDGER.

A Hedger uses the derivative market to reduce risk caused by movement in prices of shares/ securities, commodities, exchange rate, interest rates, indices, etc.

The position taken by hedger is opposite to the risk he is exposed.

Taking an opposite position to the risk exposure is called HEDGING STRATEGY.

HEDGERS

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E.g. An importer of raw material faces the risk of rise in dollar, which is very volatile, vis-a-vis the rupee. If dollar rises, the importer shall face heavy losses. So his hedging strategy shall be to BUY the dollar in derivative market, i.e. LONGING THE FUTURE of dollar.

E.g. Suppose one dollar = Rs 46/-. The hedger, in above example, LONGS a particular quantity of dollars. Now if dollar goes down to say Rs 45/-, the importer shall be able to import raw material cheaper by Rs 1/. On the other hand, he shall face a loss of Rs 1/- in derivatives. His net position is effectively neutralized. If dollar goes up to, say, Rs 48/-. Reverse holds true and the hedger is again in a neutral position.

HEDGERS

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E.g. An investor holds shares of Tata Steel, which has given a bonus 1:1. His 2000 shares have effectively become 4000 but the bonus shares have not been credited to his account due to some technical defect (change in Demat A/c).

News breaks that there is a major cancellation of a power plant in Brazil and thus a glut in steel stock. The impact shall effect steel prices, which are bound to tumble. As a result, steel producing companies shall lose heavily.

The investor can hedge his position of bonus shares by creating a SHORT position in Tata Steel securities in derivative markets. This strategy is called SHORTING THE FUTURE.

HEDGERS

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A speculator may be defined as an investor who is willing to take a risk by taking derivative position with the expectation to earn profits.

The speculator forecasts the future economic conditions and decides which position (long or short) to be taken that will yield a profit if his forecast is correct.

SPECULATORS

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E.g. If a speculator thinks that price of steel shall drop and manufacturers shall lose, he can short 2000 shares of TATA STEEL @ Rs 600/- (current price) although he does not hold OR own the shares. If the market falls to say Rs 550/-, he takes home a profit of Rs 1,00,000/-. However, if the reverse happens and Tata Steel goes up to say Rs 630/-, he loses Rs 60,000/-.

SPECULATORS

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In speculation, the player takes NAKED position, i.e. there is no corresponding exposure.

The speculator is exposed to huge risk while entering the trade for expected profit.

The risk / profit is all the more because of leverage, i.e. only margin is to be invested.

E.g. In the above example, suppose margin requirement for trading in TATA STEEL is 15%. Thus the trader shall have to pay a upfront margin of Rs 1,80,000/- only.

The profit, he earns , i.e. Rs 1,00,000/- is nearly 55% return on investment. Thus speculators are often tempted to use derivatives to earn quick bucks and as a result lose money because they carry NAKED/UNHEDGED position.

HEDGING VS SPECULATION

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An arbitrageur is an intelligent trader who attempts to make profit in a derivative market by simultaneously entering into two transactions at a time in two different markets and takes advantage of the difference in pricing. (sometimes due to reckless trading by speculators).

The arbitrage opportunities available in two markets usually do not last long because of heavy transactions by arbitrageurs when such opportunity arises .

ARBITRAGEURS

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E.g. It is expected that the price of Silver shall rise very fast. As a result, speculators take heavy LONG positions in derivative market by investing only 5% margin payment. Now silver is Rs 26,000 per kg in spot market and Rs 26,500 per kg in derivative market.

The arbitrageur seeks this opportunity, buys 10 kg in spot market and sells 10 kg in derivative markets. His position makes him stand at a surplus of Rs 5,000/-. When the frenzy dies, the prices shall stabilize/ equalize and he shall reverse the trade and earn the surplus. Alternately, he can leave delivery on expiry of contract. In both ways, he shall pocket Rs 5000/- (less brokerage, delivery cost).

ARBITRAGEURS

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Spreading is a specific trading activity in which two or more positions are taken in the same market by creating almost net nil position. Thus SPREADERS are intelligent ARBITRAGEURS who HEDGE positions in a single market by SPECULATING future pricing.

E.g. TATA STEEL February futures are trading at Rs 615/- while TATA STEEL April futures are priced at Rs 605/-. A spreader buys April futures and sells February futures, carrying a + 10 position. After some days, market falls and both Feb & April futures quote at Rs 580/-. He reverses the trade. He pockets Rs 35/- in Feb trade and loses Rs 25/- in April trade. Net profit is Rs 10/-

All the 4 types of players have an important part to play in creating competitive / universal prices and thus MAKING THE MARKET.

SPREADERS

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Risk Management DisasterBARINGS BANK

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The story of the Barings is one of a rogue trader that alone caused the bankruptcy of a supposed solid bank. This came at a big surprise and shock to everyone and especially to the finance industry as the phenomenal loss had been dissimulating for months fraudulently.

26th February 1995, the bank Barings Plc, one of the oldest banks of the United Kingdom was declared bankrupt. Nick Leeson, one of the bank's traders in Singapore had lost $1.4 billions on derivatives trading while the bank reported capital was only about $600 m. This hit came principally from a hit on a long position in the Nikkei 225 futures of notional value around $7bn on the Osaka and Singapore Exchange.

Officially Nick Leeson was arbitraging the Nikkei 225 futures contracts on the different exchanges, the Singapore International Monetary Exchange (SIMEX) and the Osaka Stock Exchange (OSE), buying the same futures at a low price in one exchange and selling simultaneously at a higher price on the other exchange. For Barings London, Nick Leeson was presumably doing a trading strategy with little or no exposure to risk as he was allegedly hedged.

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BARINGS BANK

Leeson had been the star trader of the bank. Hired as a relatively young clerk, he went to BARINGS' Singapore office in 1992. Within a year, he had made alone 10 million pounds, which accounts for 10% of the bank profit for that year. For this trading exploit, Nick Leeson was granted 1 £130,000 bonus on top of his £50,000 salary. Senior management had lots of trust in him and gave him progressively full firing power. Due to the rapid expansion of Barings Settlements, he quickly found himself in charge of both the front and back office. He would be trading on the futures market and at the same time, be in

charge of booking and reporting the various trades. In a normal day, he would work in the Singapore Money Exchange (SIMEX) until trading closed at 2pm, and then would go to the office (or 'back room') where all the records of the day's trades were recorded. This meant in particular that Nick Leeson would be the only one to check and to know if the records matched the actual sales.

Usually, a different person is doing the back office accounting, to detect any dodgy deals. However, this was not the case at Barings, giving Nick Leeson the dreadful power to cover his tracks in case of substantial loss.

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BARINGS BANK

In the end of 1994, this was way beyond the mind of the senior management of Barings, who cherishes their young trading prodigy. The huge Futures position of Nick Leeson was simply part of his trading mandate and no one would suspect any suspicious trading loss behind.Leeson's position on the Osaka Stock Exchange was publicly known as the exchange report such positions each week. Barings London thought that this long position was matched by a short position of the same notional value. This 's implies being short twice as many contracts as the Simex contracts are with a notional twice as small as the one of Osaka's contracts. But, contrary to what the senior management was thinking, Nick Leeson was in fact long the same amount in the Simex exchange.

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BARINGS BANK

Nick Leeson managed to hide his real position as he was responsible both for front and back office. Nick bought a substantial number of contracts, 11,000 on the 20th of January 1995, just three days after the earthquake in Kobe.

Probably, he thought that the market had overreacted and that the fall of the Nikkei 225 from 20,000 to 18,950 was only temporary. But the Nikkei 225 dropped even further and by Monday 23rd 1995, the Nikkei 225 was around 17,950. At the end of February 1995, Nick Leeson had leveraged his position to $7bn, holding about 61,000 contracts (55,000 March contract and 6,000 June contracts). His position on the Simex was 8 times bigger than the next largest position.

His position was too big not to be discovered. The margin calls were enormous and Barings Tokyo London had to transfer urgently a massive $835 m to Barings Singapore in January and February to cover the margin calls on Simex. These calls made finally Barings bankrupt as its reported capital was only of $635m.

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BARINGS BANK

Nick Leeson who was one of the golden boys of the bank, was arrested and he received a 6 and a half year sentence.

The Bank of England had to close Barings, also known as the Queen's bank since it was used by Elizabeth II. Barings Shareholders lost $1bn. Eventually Barings was sold to ABN-Amro for a symbolic £1.

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BARINGS BANK

CA Kapil Agrawal

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