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Set up a reliable Risk Management UnitBarings’ failure can be attributed to not having set up a reliable risk management unit. The speculative trades were subject to the full range of market risks including interest rate risk and currency risk.In addition, credit risk was mismanaged in the sense that no one questioned why Barings was lending big amounts to its clients, nor had anyone looked up or conducted any research on these clients. Risk MitigationImpose strict trading limitsBarings did not place any limits on their trading operations in Singapore . Leeson certainly took advantage of thisby placing huge bets through trading derivatives.Setting trading limits is crucial, especially for naked positions, because it will limit the potential loss. Even for hedged positions, it helps to have a gross limit as hedged trades are still exposed to basis and settlement risks.Stop irresponsible doubling down amid huge lossThe total loss could be much less fatal should Leeson’s activities have been discovered and stopped one month earlier. The loss would probably be absorbed by Barings, saving the bank from bankruptcy.Barings management may even have known about Leeson’s exposures and allowed him to expand his bets as their only chance to avert disaster .Strategies could have worked betterHigh rewards come with high risk. Had Nick been constrained to arbitraging only, Barings’ fall could have been avoided. The switching business entails little market risk. It produces stable long-term profits with proper calculation and execution.Option payoffs distribution for the short party is left-skewed, with frequent positive returns and occasionally large losses. Nick could have purchased out of money options on Japanese volatility index to insure against a sudden upsurge in volatility.pg. 3
Appendices:Figure 1 A Timeline for Barings’ CollapseFigure 2 Nikkei 225 Index Performance from 1970 to 19961/22/19709/22/19706/2/19712/4/197210/5/19726/14/19732/19/197410/23/19747/2/19753/11/197611/12/19767/21/19773/30/197811/30/19788/7/19794/14/198012/16/19808/24/19815/6/1982