Nick Leeson has become a sort of fable in the
investment banking world. His story, right along with the story of
The Boy Who Cried Wolf has become a benchmark of what you should not do in life.
Leeson is the individual who is solely responsible for the 1995 demise of
Barings Bank, one of the oldest and most respected
Investment Banks in the world. Here is how Nick killed an old and wealthy giant.
Leeson was a futures and options trader. His specialty was trading options that indexed different markets, such as the Hang Seng the Dow Jones. These options let people buy into the market as a whole at lower prices as well as let them hedge against their losses. Nick thought he saw an arbitrage opportunity (an opportunity to make a profit risk-free), and acted on it. However, what Nick saw was not an arbitrage, but rather just a normal market working. As a result, he bet, and he lost big.
What Nick tried to do is called a straddle. This strategy allows one to buy two options, one short and the other long in the same market, so whether the market goes up or down, you still win. When it goes one way, one option becomes worthless, but the other one becomes very valuable. A worst case scenario is that the market does not go either way, and both your options are worthless.
Leeson saw that the price quoted for the same futures for the Singapore Stock Exchange were trading at different prices in Singapore and Tokyo. He thought that he would profit by buying in the cheaper market and selling in the more expensive one simultaneously. However, because of the time difference between the two markets, he had to wait overnight and cash out first thing in the morning. Nick set up his position by selling short in both markets, a short straddle. This position is exactly the opposite of the straddle described above: You win if the market stays the same, but lose big time if it moves in either direction. An extremely dangerous position to be in. Nick got the money and clearance to do this from his superiors, who were very careless.
Nick probably slept well that night, hoping to make a tidy profit in the morning. However, while he was sleeping, an earthquake hit the Kobe region of Japan, causing the Asian markets to fall rapidly. As a result, Nick's position, which he thought was secure, turned out to be worse than he could possibly imagine. Overnight, a firm with billions and billions in assets was now on the verge of bankruptcy.
As a result of his foul play in getting clearance for his trades, Nick was fired and arrested. He is still in jail. In a recent interview from prison, it became clear that Leeson didn't really know what he was doing, and didn't realize how dangerous his position was. He compared it to gambling, saying he bet and lost. But gambling has some strategy. Nick wasn't just gambling, he was playing the lotto! His chances of winning were next to nothing. Barings Bank, may it rest in pieces.