Title: “Total Risk: Nick Leeson and the Fall of Barings Bank”
Author: Judith H. Rawnsley
Length: 206 pages
Price: $24.00
Reading time: 6 hours
Reading rating: 4 (1=very hard, 10=very easy)
Overall rating: 2 (1=average, 4=outstanding)

Reviewed by Robert F. Mulligan

Special to the Asheville Citizen-Times.

Nick Leeson was an obscure derivatives trader in the Singapore office of Baring Securities, until his illicit options trades bankrupted Baring Securities and its parent Barings Bank, an institution so old and venerable it had helped finance the Napoleanic Wars.  Leeson lost over a billion dollars, more than Barings’ capitalization.  Starting with his arrival in Singapore in 1992, Leeson began losing money through uncovered options contracts written on the Japanese Nikkei 225 stock index.

To understand how Leeson broke the bank, we need to understand the derivative instruments he used, which were primarily options based on the Nikkei 225.  The Nikkei 225 Index is a price-weighted index of 225 Japanese blue-chip stocks.  Like the Dow Jones Industrial Average for the U.S., the Nikkei consists of companies selected to be representative of the Japanese economy.

An option confers the right, but not the obligation, to buy or sell an underlying asset at a specified price, called the strike price, on a specified future date.  The underlying assets for Leeson’s Nikkei options were bundles of Japanese blue-chip stocks.  There are two kinds of options, puts and calls.

A put option written on the Nikkei index provides the buyer the right to sell the underlying stocks at the strike price.  A put option has no value unless the value of the Nikkei index falls below the option’s strike price.

A call option gives the buyer the right to buy the Nikkei stocks at the strike price.  A call option has no value unless the Nikkei index rises above the strike price.  Leeson constructed an options-trading strategy called a straddle, based on selling both calls and puts with the same strike price.

The best outcome for him was that on the exercise date, the Nikkei index would hit the strike price exactly.  Then both options would expire worthless – after all, they only gave the buyers the right to buy and sell stock portfolios at the going market rate, something anyone can always have for free.  Then Leeson could keep the price the buyers had paid for the options, a pure profit for Barings.

A similar strategy called a strangle, where the call is written with a lower strike price than the put, provides the maximum profit if the Nikkei stays between the call and put strike prices.  Unfortunately for Leeson and Barings, the Nikkei sometimes rose faster than he anticipated.  The amount of profit he could have earned on each straddle or strangle he sold was fairly modest, usually less than ten percent of the value of the Nikkei shares.  However, whenever the Nikkei went out of the safe range for his straddles and strangles, he lost many times that much.

Leeson sold uncovered calls, which are particularly risky.  A call option is said to be covered if the seller owns the underlying asset.  If an option buyer chooses to exercise the call, because the market value of the stocks is greater than the strike price, the seller of the call must then sell the underlying asset at the below-market strike price, that is, at a loss.  But if the seller already owns the asset, the loss cannot be greater than the seller can afford.  Leeson’s uncovered calls are what broke Barings.

Because of incredible incompetence and lax oversight on the part of his superiors at Barings, as well as the official regulatory authorities in the U.K. and Singapore, he was able to conceal his losses in secret accounts for two years.  If he had been caught and cashiered early on, Barings would still be with us.

The more Leeson lost, the more he put into risky uncovered calls, straddles, and strangles.  He was no different from a bank teller who takes the bank’s cash to the racetrack or the casino with the intention of replacing it as soon as he wins enough – which is why he’s in jail now.  The more he lost, the more he wagered.

Judith Rawnsley provides an entertaining and anecdote-strewn account of Barings’ problems and Leeson’s escapades.  She also cuts through the nearly impenetrable financial jargon of the derivatives business nearly as well as anybody ever will.

Robert F. Mulligan is visiting assistant professor of economics, finance, and international business in the College of Business at Western Carolina University.  His research interests are monetary and international economics and he is a fierce fan of the Asheville Smoke.  For previously reviewed books, visit our web site at www.wcu.edu/cob/bookreviews.