An arbitrageur is an intelligent trader who attempts to make profi t in a derivative market by simultaneously entering into two transactions at a time in two diff erent markets and takes advantage of the diff erence 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 .

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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 profi ts.

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

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Brief Story- Barings Bank

Arbitrary - derivative trading of Singapore and Japan

Nikkei 225 contract traded

on SIMEX and OSE

10 –year JGB (Japanese government bonds)

contract dealt in SIMEX and OSE.

3-month Euroyen contract dealt in SIMEX and TIFFE (Tokyo Financial Futures Exchange) in the Japan.

Derivatives

1 2 3

Derivative trading strategy

Hedging• Interchange-arbitrary

Brief Story- Barings Bank

strategy implemented

Buy and sell Nikkei

225 futures

contracts simultane

ously

Gain the

arbitrate profit

Inter-exchange arbitrate strategy

Long/short future position long Nikkei 225 futures on both SIMEX and OSE short Japanese government bond futures short position in Euroyen futures

SPECULATION

6

Performance of Nikkei 225 after Kobe earthquake

Straddle strategy Leeson’s strategy amounted to a bet that the Japanese stock market would neither fall nor increase by a great deal—any large movement in Japanese stock prices would result in losses

simultaneous sale of both calls and puts onNikkei-225 futures

Leeson's Positions as at End February 1995.

  

Number of contracts1

nominal value in US$ amounts Actual position in terms of open interest of relevant contract2

Reported3 Actual4

Futures

Nikkei 225

30112$2809 million

long 61039$7000 million

49% of March 1995 contract and 24% of June 1995 contract.

JGB15940$8980 million

short 28034$19650 million

85% of March 1995 contract and 88% of June 1995 contract.

Euroyen601$26.5 million

short 6845$350 million

5% of June 1995 contract, 1% of September 1995 contract and 1% of December 1995 contract.

Options

Nikkei 225

Nil

37925 calls$3580 million32967 puts$3100 million

1. Expressed in terms of SIMEX contract sizes which are half the size of those of the OSE and the TSE. For Euro yen, SIMEX and TIFFE contracts are of similar size.2. Open interest figures for each contract month of each listed contract. For the Nikkei 225, JGB and Euroyen contracts, the contract months are March, June, September and December.3. Leeson's reported futures positions were supposedly matched because they were part of Barings' switching activity, i.e. the number of contracts on either the Osaka Stock Exchange, or the Singapore International Monetary Exchange or the Tokyo Stock Exchange.4. The actual positions refer to those unauthorized trades held in error account '88888'. Source: The Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Commons, Her Majesty's Stationery Office, 1995