FINC20019 Capital Market Analysis: Immense Risk and Volatility

Questions:

Task:

Demonstrate your understanding of money and capital markets and financial institutional risk. You are required to research and report on the Nick Leeson story and provide explanations for related issues such as the importance of institutional capital and risk management and the fundamentals of futures contracts.

1.Central to the story are futures contracts. Define a futures contract and describe the basic principles behind the use of futures contracts to manage risk exposures.

2.For investors and borrowers considering setting up a risk management strategy using futures contracts, there is a basic rule that determines the timing of the various buy/sell transactions.

a.Explain this rule [examples from the Nick Leeson story will be highly regarded].

b.Outline the procedure involved in buying a futures contract.

c.Indicate the implications of being long or short in a futures contract.

d.What are the procedures for closing out these positions prior to delivery?

3.Describe how the Barings management failed in their duty.

4.Explain why risk management is important to the long-term survival of a corporation including:

a.Define and explain the nature of risk and the purpose of risk management.

b.Discuss who is responsible for the establishment of risk management objectives, policies, procedures and strategies in a corporation.

5.In light of the Nick Leeson case:

a.Comment on the logic and reasons why risk must be identified, measured and managed.

b.Briefly explain the main functions of capital.

c.Provide an overview of the Basel II capital accord framework of three pillars which established the minimum capital required by a bank and incorporates risk components: credit risk, operational risk and market risk (i.e. define credit risk and explain how a bank calculates its minimum capital requirement.

d.Briefly describe / compare the different types of acceptable capital under the Basel II and Basel III capital accords.

Answers:

Introduction

Futures are exposed to immense risk and volatility. In short, risk and reward are equally balanced. Therefore, due consideration needs to be provided in terms of operation and the market scenario. The case of Baring, a giant in the banking field in the UK was completely wiped out owing to the fraudulent practices of Nick Leeson. When the practice of Nick reaped benefits no questions were hurled, however, with the due passage of time, the activities were so scattered that Baring was incurring losses amounting to 50% of the capital. To recoup the losses, Nick entered into more risky strategies that ultimately ended the run for Baring. Therefore, implies the pros and cons for futures (Monthe, 2007). It has reward potential but even contains risk that can erode all the funds in a quick span of time.

1. Future contract

A future contract is a legal agreement and is done on the floor of a recognized stock exchange. The main crux of the future contract is to purchase or sell a specific commodity or financial instrument at a particular time in the future. A future contract is standardized in nature and traded on a future exchange that rests on the asset that is underlying in nature along with the detail and quantity. The use of a future contract is done by a hedger and a speculator (Pilbeam, 2009).

The future contract can be described as the most useful derivative that can be used for hedging the risk. The main reason for using this derivative equipment is to offset the risk. When a company is certain of purchasing in the future for a specific item then it considers a long position in the future contract so that the position can be hedged. On the other hand, if the company or a person is certain that the item will be sold then it will take a short position (Lawrence, 2011). Hence, the timing of the market is an important consideration and the steps that are taken is meaningful. The basic principle that is followed is that the contracts are designed in a manner that helps the management of tot take a stand against various kinds of risks. Secondly, from the management end, if the gold price increases, the gold price enhances in the physical market, the underlying gold future contract will decline (Pilbeam, 2009). The price change in the two will offset one another and hence, the uncertainty risk will be removed.

2. Rule that ascertains the buying and selling transactions

a.In the year 1995, the financial market felt a huge jolt owing to the huge scandal. Nick Lesson lead to the losses of Barings, one of the pioneersin the banking arena in the UK. The management and the internal control of the bank were weak because no fraudulent activities were traced. At the end of the year 1994, the total losses soared ar 208 million pounds that were almost 50% if the Barings capital. To make up for the losses, Leeson entered a short straddle on the Singapore and Nikkei Stock exchange in the pretext that the Nikkei will drop below 19,000 however, the strategy was knocked out due to the earthquake in The further riskier position was entered into by Leeson that made situation worst. When the situation was out of control and the bank was in a situation of crisis, Lesson fled leaving a note (Smiechewicz, 2002). This led to the bankruptcy of the bank and create a worldwide problem

b.The buy and sell transactions depends upon the various Future transactions depend upon the timing and the position taken. In the case of Baring, Leeson took a positionas per the worldwide happening and tried to make a huge profit by undergoing riskier positions. For example, the short straddle position in the case of Singapore and Nikkei. Such a position was entered to take advantage of the situation prevailing in the global market (Hull, 2005). However, it needs to be noted that the rule is subject to various factors and such factors influence the overall impact.

c.Buying and selling future contract can be considered the same as buying and selling of stock but the immediate delivery concept is absent. To buy future contract one of the major requirement is to have a trading account to deal in the derivative segment. Secondly, money is the major consideration because this need differs in the case of a derivative segment (IASG, 2015). When a purchase of stock is done in the cash segment, the total amount of the shares needs to be paid and differs slightly for a day trader. In future, the upfront payment needs to be done known as the margin money. It helps in reduction of the risk that the exchange undergoes and maintain the decorum of the market. The order needs to be placed with a broker providing the details such as scrip, contract size, month, etc. once it is done, the margin money is provided to the broker that ensures the buying process

The long future position can provide a profiton an unlimited basis with unlimited risk and is generally eyed by the future speculators to benefit from the underlying price rise. It is used when a manufacturer strives to lock in the price of a commodity or a material that he needs in the future course of time. The diagram shows unlimited profit capacity with risk on an unlimited

(The Options Guide, 2016)

The short future position is even a scenario where there is unlimited profit laced with the unlimited risk that can be opted by the speculator to profit from the fall in the underlying prices. It can be used by a speculator who wants to sell in the future (The Options Guide, 2016).

(The Options Guide, 2016)

d.Before the delivery,the position can be settled through the process of liquidation that is even termed as offset and reversing trade. The transaction is completed by bringing the net position of an investor to zero. Back to zero does not indicate a scenario of no profit or loss rather indicates that the investor purchased a particular number of commodities to be delivered on a prescribed on a certain date. The same number of contracts is sold for the same commodity on the same date of delivery (Zacks, 2015).

3. Failure of Barings management

The Barings management failed in their duty owing to the weakness in the internal control system and the inefficiency on the part of the management. Leeson made a speculative trade that was unauthorized for Baring however when it reaped huge profits the company tagged him to be the best and effective. However, Lesson entered into many fraudulent activities that were against the normal course of business, however, in the lust of creating wealth, the company ignored all the activities of Leeson and ultimately it led to the humongous loss that wiped the company out of the market (Matthew, 2015).

4. Importance of Risk Management

a. Nature &purpose of risk management.

The term risk can be defined as a scenario undertaken in which there always occurs a situation of some loss to be borne, thus the risk is a very important factor for all areas concerned. Risk can also be regarded as intangible till an actual loss occurs in life or when a close survival is made from such risks (Vause, 2009). The nature of risk can be of different perspectives for different department of organisations, different projects, management team and also common stakeholders, however risk nature can be of two types such as positive one in which the risk is attached with an opportunity and simultaneously measures are taken in positive way to increase success in those opportunity (Douglas et. al, 2015). Risk can be of negative nature also which is a sign of hindrance, loss, and uncertainty in the path of success and proper measures should be taken to overcome such negative risks. Risk management is a way to identify and to respond strategically to the risk factors associated in the best possible way. The purpose of risk management is to find out what type of risk is associated with a project or organisation, to reduce and overcome such risks by making suitable strategies and plans (Douglas et. al, 2015).

b. Responsibility for the establishment of risk management objectives, policies, procedures and strategies in a corporation.

Risk Management can be defined as a method of identification of risk, evaluation of risk and a strategically taken out way to overcome such risks in the best possible way. The implementation of risk management is a duty for all concerned departments of a corporation. However the establishment of proper strategies of overcoming risk, the policies to be made and the procedures to be followed should be the prime responsibility of the Directors and promoters of the corporation as they are the ones who knows the motive of the corporations, the advantages and disadvantages associated with it (Coram et. al, 2011). They have the duty to properly design each and every risk management policies to be fulfilled by the concerned department. Being directors and promoters they are very well acquainted with the type of transactions involving different types of risks associated with such transactions. Therefore they should take much importance in establishing a proper due diligent management in the corporation. The objectives and the procedures for implementation are the responsibility of senior management personnel to analyze whether the risk management policies and procedures are well followed by all the concerned departments and employees of the corporation. It is their responsibility to check that all the laws and regulations are correctly followed by the organization; the employees are properly trained to bear risk appetites efficiently. The departments of the corporation are always informed well ahead of the changes and updations made in the risk management system. The proper bonding of sharing responsibility by the directors, promoters and senior management personnel can establish an efficient risk management system (Kalpan & Schoar, 2005).

5. Nick Leeson case

a. Identification of the risk and management

Any type of risk must be identified at the very beginning because it helps in designing a proper course of action. When risks are traced at the beginning, steps can be taken to neutralize the impact. It helps in management, as well as measurement. Some risks are inherent in the system and hence, a proper course of action or internal control must be present to negate the action. Identification of the risk at the very beginning helps in knowing the level of danger where the company is exposed and the risk aversion measure can be done accordingly (Christensen, 2011). For example in the case of Baring, if the fraudulent practices of Nick were identified at the very beginning then measures could have taken to prevent the total shutdown of the company.

b. Main functions of capital.

The main functions of capital are it helps in establishing any organization through funding such as purchasing of raw material, machinery. Capital meets the cost involved in continuing the growth of organisations such as transportations costs, provides a channel for connectivity which cannot be met without proper allocation of the fund in business or organization (Goyal & Wahal, 2008). Capital helps in paying remuneration to employees as well as wages to labors involved. The enterprises, businesses or organizations cannot grow without proper and efficient marketing which requires a good amount of capital to be invested in this area thus one of the main functions of capital is boosting the marketing department of any business. Capital helps in acting as a nucleus to the productivity of all departments of an organization, providing basic facilities for the flourishment of businesses (Guan et. al, 2008). Thus we can say capitol acts as a base on which all enterprises and business set pillars of success.

a. Overview of Basel III

The Basel Committee was established towards the end of 1974 previously named as the Committee of Banking Regulations & Supervisory Practices. It was set up by the Central Bank Governors comprising of a group of countries knowingly ten countries. The aim of Basel Committee is to improvise and establish an efficient financial stable condition for banks worldwide by setting up proper supervision technique and by-laws for the banks and be as a link of channel cooperating with all the countries banking supervision of the member countries. Basel II came up in June 2014 for changes in the international banking standards with an intention to supervise and control the minimum amount of capital needed to be kept by banks in order to be secured against the solvency and economic stabilization. Credit Risk is a situation where the default risk on the amount borrowed failed to be paid back or default in payment by the borrower. The risk can be full or partial, the more the borrowing cost the higher is the chances of credit risk (Brown et. al, 2006). The calculation method used by banks to calculate how much minimum capital a bank should according to its risk appetite are by using the method of definition in regulatory capital and risk-weighted assets.

b. Various types of acceptable capital under the Basel II and Basel III capital accords.

Basel II capital accords established in 2004 had international banking regulations and guidelines for efficient capital stability in banks, thorough supervision of risk management processes and the disclosures to be made by the banks. It had set stringent guidelines to be followed so as proper capital adequacy can be assessed by market participants. The different acceptable capital under Basel II is divided into three tiers. Tier I includes equity capital of shareholders, the earnings which are retained, reserves which are disclosed. Tier II includes all acceptable capital under Tier I and various other instruments such as reserves of banks, instruments which come as hybrid and another medium as well as long duration loans which are subordinated. Basel III came into a scenario in 2010 after the worldwide financial crisis took place in 2008 due to failure in Basel II instruments. Basel III started with a prime focus on capital, funds, liquidity and leverage. It aimed at establishing a procedure that can promptly recover from the financial crisis faced and come back with economic stability in banking supervision. High-Quality liquid assets were introduced to prevent bank run situations, Tier I capital was fixed at a certain percentage, and leverage ratio was to be calculated by making a division with Tier I capital and the average sum of consolidated assets of banks (Hoffelder, 2012).

Recommendation

The evaluation and proper implementation of risk management policies will help in time to improve and grow a project, department or organisation by quickly turning positive risks into wide opportunities and negative risks into cost effective and in prevention of losses. Risk management also enables in time to inform concerned departments about the problems and solutions to be taken to evaluate such risks. The downfall of Baring is an apt example where the management failed to take hold of the position and ultimately led to the downfall. Hence, strong internal control is the need of the hour that can trace any issue that concerns the organization.

Conclusion

Going by the overall discussion, it can be commented that the derivative instruments helps in mitigation of the risk however, there is a high level of risk. Therefore, one needs to be efficient so that the market can be studied properly. An improper judgment can ruin the entire wealth. Moreover, the management should ensure a strict control over the funds and the internal happenings. The case of Baring showcases that weak internal control and deficiency on the part of the management can lead to immense losses and ultimately the wind up of the organization.

References

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Christensen, J. (2011). Good analytical research. European Accounting Review, 20(1), 41-51

Coram, P, Mock, T. J, Turner, J. & Gray, G. (2011). The communicative value of the auditor’s report. Australian Accounting Review 21(3), 235-252.

Douglas M.B, Todd, D.F & Hermanson, D.R. (2015). The Effects of Internal Audit Report Type and Reporting Relationship on Internal Auditors' Risk. Judgments.Accounting Horizons, 29(3), 695-718.

Goyal, A & Wahal . S. (2008). The Selection and Termination of Investment Management Firms by Plan Sponsors. Journal of Finance, 63, 1802?1827.

Guan, L, Kaminski, K. A & Wetzel, T. S. (2008). Can Investors Detect Fraud Using Financial Statements: An Exploratory Study. Advances in Public Interest Accounting, 13, 17-34.

Hoffelder, K. (2012). New Audit Standard Encourages More Talking. Harvard Press.

Hull, J.C. (2005). Options, Futures and Other Derivatives. Prentice-Hall,

IASG. (2015). Advantages & Disadvantages of Call Options for Hedgers & Speculators. Retrieved May 29, 2017 from https://blog.iasg.com/2015/06/19/advantages-disadvantages-of-call-options-for-hedgers-speculators/

Kalpan, S.N & Schoar, A. (2005). Private Equity Performance: Returns, Persistence, and Capital Flows. Journal of Finance, 60, 1795?1823.

Lawrence G.M. (2011). McMillan on Options. John Wiley & Sons.

Matthew, S. E. (2015). Does Internal Audit Function Quality Deter Management Misconduct?. The Accounting Review 90(2), 495-527

Monthe, P. (2007). How Nick Leeson caused the collapse of Barings Bank. Retrieved May 29, 2017 from https://www.next-finance.net/How-Nick-Leeson-caused-the

Pilbeam, K. (2009). Finance and Financial Markets. Palgrave Macmillan

Smiechewicz, W.J. (2002). The Baring Bank Case. Retrieved May 29, 2017 from https://www.fraud-magazine.com/article.aspx?id=4294968220

The Options Guide. (2016). Long Future Position. Retrieved May 29, 2017 from https://www.theoptionsguide.com/long-futures.aspx

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Zacks. (2015). The Advantages of a Call Option, Retrieved May 29, 2017 from https://finance.zacks.com/advantages-call-option-1224.html

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