Techniques for trading Asian markets

Futures, Feb 2008 by Ruggiero, Murray A Jr

In the first installment of this series, we looked at what's available to the futures trader in the Asian arena. In this article, from the lessons learned from Nick Leeson to Tokyo's monetary policy, we examine the ins and outs of trading Asian markets, focusing on intermarket analysis techniques.

Asian markets are no stranger to financial scandals. However, in 1995, a scandal broke that may not be history's largest in monetary terms but arguably is the most infamous. By losing about $1.4 billion, Nick Leeson singlehandedly brought about the collapse of the Barings Bank, one of the oldest and largest banks of the United Kingdom.

We can learn a lot from the collapse of Barings Bank. Indeed, before its downfall, Barings Bank was expanding significantly.

At that time, Barings was trying to absorb a recent merger, leaving Leeson without a direct supervisor. Moreover, the bank wanted to expand the Singapore operation, which started in 1987. Next, Leeson had a reputation as a star trader. However, he actually was much more than that. Leeson's effective role had grown to trader/general manager/back-office manager. Bottom line, he was able to operate with few or no checks and balances.

Leeson's broad and powerful role should have sent warning signals to management. However, his seniors either did not notice the conflicts of interest or were plain careless. Problems eventually, possibly inevitably, arose as Leeson misused his authority due to greed and hubris. He went so far as to create a fictitious account to cover up his errors instead of arbitraging them out to mitigate risk. Account No. 88888 took a lot of abuse at the hands of Leeson.

Leeson speculated primarily on Nikkei 225 futures and Japanese government bonds (JGB) futures, as well as Nikkei options. All this had dramatic implications for the bank, which had few positions in the markets that Leeson was trading to spread out institutional-wide risk.

Unfortunately for the rogue trader, he continuously lost money. However, he kept increasing his position and by midFebruary 1995, he accumulated half the open interest in Nikkei and 85% of the open interest in the JGB.

Amazingly, no one noticed his losses.

Stephen J. Brown and Onno W. Steebeck analyzed the markets that Leeson traded, with respect to price and volume patterns. They also studied the daily volume, open interest, opening, closing, and highest and lowest price. Their findings are documented in Doubling: Nick Leeson's Trading Strategy published in the Pacific-Basin Finance Journal in 2001. Leeson also tells his tale at: www.nickleeson.com.

In short, as prices fell, Leeson doubled his position. The rationality was an assumption that the price and volume are correlated (asymmetric relationship). Thus, in the case of a long (short) position, a price fall (rise) would be followed by a significant volume increase, while a price rise (fall) would not. Moreover, a trader following the above strategy would start doubling his position only after the price crosses a certain threshold. The idea is that by doubling you are attempting to exploit some perceived market inefficiency.

Brown and Steebeck analyzed the price, volume and open interest data, plus Leeson's equity curve. They determined that Leeson's losses would increase with a falling Nikkei index and rising JGB futures prices. Then, they broke the period before, during and after the scandal into five different intervals and analyzed the numbers relative to Nikkei and JGB futures returns the day before.

1. Base period July 1,1994-Oct31,1994

2. Heavy trading: Nov. 1, 1994 - Jan. 16, 1995

3. Between the Kobe earthquake and Leeson's departure: Jan. 17, 1995 Feb. 23,1995

4. Uncertainty prevails; ING takes over Barings Liabilities: Feb. 24, 1995 - March 10, 1995

5. Stabilization: March 11, 1995 July 1, 1995

Following the Kobe earthquake, Leeson increased his trading volume considerably. He ramped up his already considerable position in Nikkei futures on the Osaka securities Exchange (OSE) of 3,000 contracts by six times or more. Although it appeared he had this position offset by an equivalent position on the Singapore International Monetary Exchange (Simex), that was a mirage. In fact, Account 88888 held an equal number of long positions that were not offset.

Market prices reflected Leeson's shenanigans. The premium of the Simex contract increased with Leeson's heavy trading and expanded significantly following the earthquake and the acceleration in Leeson's position size. The lesson we can learn from this story is that markets can be, have been and will be manipulated again.

IN THE WAKE OF DISASTER

If a single trader can bring about such a turn in the markets, what about governments? Due to the official policies of Japan, that country's economy and stock market have not yet recovered from the real estate and stock market crash of 1989-1990.

One of the key features of the Japanese economy has been artificially low interest rates. Due to this, the carry trade, borrowing of money in Japan and putting the same in U.S. bonds, worked well for a long time. However, if interest rates appear artificially low for some time, then inflation can occur, which if left uncontrolled can lead to stagflation.