DERIVATIVES AND RISK MANAGEMENT

i.

Derivative trading refers to investment in financial contracts whose value is derived an

underlying asset. Derivative markets were established in the middle ages to meet the needs of
farmers and merchants. It has become one of the biggest markets in recent times and fast
growing globally.

The volatility of the economic environment led to rising concerns with finding new ways
reducing such exposures. Consequently, derivative trading became the innovation that addresses
these concerns. The common types of derivative include options, futures and swaps.

Despite the enormous benefit of derivative trading Barings Bank went bankrupt through
derivative trading. Derivatives are traded either in a regulated exchange or over-the-counter
(OTC). Over-the-counter derivative trading poses a significant risk sink there is no regulation
although it serves an important economic function. The misuse of OTC derivatives has the
tendency to plunge a firm into crisis. Barings Bank and Lehman Brothers Holdings failed as a
result of factors including unethical business practices, risky derivative trading, dubious
accounting practices and lack of oversight on employees performance.

According to history, Barings Bank of England, once vibrant and regarded “too big to fail” by
the global sector collapse in 1995. The collapse was attributable to an employee named Nick
Leeson who indulged in secret and ambitious derivative trading. He reportedly diverted funds
and concealed losses in options trade.

With an asset base of $639 billion and debt of $619 billion, Lehman Brothers initiated
bankruptcy proceedings in 2008, making them the largest ever bankruptcy proceedings in the
history of the United States if America. According to Wiggins, Piontek and Metrick (2014), they
revealed that at the time of Barings Bank failure, it was considerd the fourth largest investment
bank with estimated strength of 25,000. Barings Bank had a dramatic rise but thereafter
experienced a distressful situation forcing it to file for bankruptcy in the 3 rd quarter of 2008. The
collapse had a toll on employees and their families.
Lehman Brothers was also engaged in derivative commercial activities with estimated 5%
outstanding of the world’s derivative engagement (Wiggin et al 2014; Sarno & Martins 2008).
Lehman’s collapse was indeed a surprise to many. It was however revealed that its balance sheet
did not reveal the type of business it engaged in although it showed concentration of most
important instruments.

These two firms being discussed share some similarities that caused their failure. Both firms
have similar reasons for their collapse. They were ambitious in the potential gains from
derivative trade. Beside their core business they believe that, they could make gains from
derivative trading to against losses in other commodities trading. Interestingly, Nick of Barings
Bank secretly engaged in options and futures investment. Lehmans Brothers also engaged in
highly speculative and Ponzi derivatives which were fragile as a form of leverage (Minsky
2016). Before the collapse, Lehman Brothers engaged in numerous risky and unproductive
investment beside huge residential loans. These undoudtedly played a role in its collapse
(Murphy 2008; Kimberly 2011). Liquidity crisis was also similar to both firms. The two giant
firms wer unable to immediately honor claims by their creditors. Lehman lost confidence as most
banks refused credit facilities in spite of their assets base (D’Arcy 2009). Consequently, the
confidence of customers and investors eroded as a result of high debt to equity ratio (Mensah
2012). Barings Bank was equally faced with serious liquidity and credit risk.

In addition to the above, the two banks indulged in unendorsed corpaorate gou=vernance
pratices, dubious mechanisms and unacceptable accounting pratices (Caplan, Duta & Lawson
2010). Nick Leeson of Barings Bank created shadow bank accounts to hide losses from secret
deals. Lehman Brothers adopted “creating accounting” to portray the bank as performing well
and in good standing.

Despite the similarities in the two firms, they had some distinguishing features. It was observed
in Lehman Borthers that they have an exorbitant compensation scheme for executives and
violated various regulated standards. Within a period of nine years, an estimated amount of $300
million was paid to the executive director with increase in bonus of $480 million even at the time
bankruptcy was eminent (Bebchuk et al 2010). Some analysts also identified complex capital
structure to have been one of the causes of its bankruptcy (Steinberg & Snowdon 2009). Another
revelation about Lehman collapse was that management illegally applied the purchase agreement
(Repos 105) to aid in manipulating accounting figures in their financial statements to look
attractive to the public.

On the part of Barings Bank, there was no segregation of duties among employees. Barings was
also characterized by unnecessary bureaucracies in carrying out daily task. Coupled with the
bureaucracy in management inefficiency which made them unable to detect the nefarious
activities of Leeson over a long time (Samuelson 1996). Employees activities were not
monitored.

ii.

Barings Bank and Lehman Brothers painful crisis provide great lessons for investors and
regulators. The presence of a regulated market place is essential to withstand shocks in the
future. Regulation of foreign exchanges require regular market surveillance and protection of
customers funds. Insider trading was shielded with pretense. Management should have adhered
to audit advice on Leeson secret deals. It is eminent from the above that the collapse of the two
firms spans from unethical business practices, risky derivative trading, dubious accounting
practices to lack of oversight on employees performance

2.

The term credit derivative refers to a financial contract that allows parties to minimize their
exposure to credit risk. Credit derivatives consist of a privately held, negotiable bilateral contract
traded which is traded over-the-counter (OTC) between two (2) parties in a creditor/debtor
relationship.

Credit derivatives serves as tools to hedge credit risk exposure by providing insurance against
losses suffered due to credit events. They are flexible and thus provide users with advantage
mainly because they are OTC products and can be designed to meet specific user requirements.
Investors in a derivative market are either hedgers, speculator or arbitrageurs. Hedgers anticipate
exposures to an underlying asset which is subject to price risk, they try as much as possible
minimise lossess. Speculators in a derivative market looks at the future direction of prices that
would earn him profit. Arbitrageurs considers avenues for making riskless profit from
investment.

There are various kinds of derivatives, each with its own purpose and rule of exchange. Credit
derivatives has become more refined to improve business operations with great efficiency.

The relevant of credit derivative in modern financial system is not farfetched. Investors who
have risk they do not want are ale to transfer it to those who have the appetite for it. Credit
derivative also improve the intermediation process by enhancing market liquidity, efficiency and
completeness.

Credit derivative trading offers insurance against default for investors and as well the quality of
debt and frees up capital for investment.