By Robert Hunter

Nick Leeson, the 20-something futures trader who single-handedly brought down Barings Bank in 1995, began writing an account of his exploits soon after he arrived in Singapore’s Changi prison. Rogue Trader, the book, is a vivid but maddeningly self-serving cautionary tale of the dangers of a derivatives operation run amok.

Now, Leeson’s story is being told again, on a much grander scale. “Rogue Trader,” a feature film written and directed by “Fatal Attraction” writer James Dearden and starring Jedi Knight Ewan McGregor, recently began an exclusive limited engagement on the cable network Cinemax. The cinematic version is generally faithful to the book’s account of the events, but Dearden’s skillful adaptation resonates far more than the original.

Films based on the financial world are usually painted in broad strokes. Even the best of the recent contributions to the genre—1988’s “Wall Street” and 1992’s “Barbarians at the Gate” come to mind—focus on the shopworn themes of avarice, lust and machismo, without much consideration of the more complex workings of the human psyche. “Rogue Trader” is subtler: Nick possesses neither insatiable greed nor unquenchable lust for power. His motivation is merely to make his deceased mother, his wife and his father, a plasterer, proud. This desire to please others ultimately leads to his downfall.

McGregor succeeds in conveying, in bile-swallowing candor, what it’s like to be constantly on the wrong side of the market. In Nick’s case, the market is also a metaphor for the class system he has tried to leave behind. Nick’s working-class background is established in the film’s deft opening scene: When Nick’s drunken friend Steve makes a lewd sexual gesture to a young woman in a London nightclub, the woman’s friend hurls a chair that accidentally hits Nick in the face. Nick is thus introduced as a victim of circumstance—a theme that the film, like the book, revisits often.

“Rogue Trader” is not without its flaws. Its depiction of Nick’s trading losses is thin: the 88888 account balloons with little explanation, and Nick’s efforts to reduce the position get short shrift as well. The dialogue is occasionally stilted, as characters delve into unnaturally expository language for the benefit of the audience. Some of the expressly educational material is uneven—there are detailed definitions of futures contracts and margin payments, for instance, but not options, leading one to believe that Nick’s claim of collecting “commission in-gain” from his options trades, rather than premium, is more than a misnomer. In one questionable sequence, Nick, in a voice-over, says he stands to make a killing if the Nikkei moves to 19,000 as a result of all the options he had been selling. But the book version notes that Leeson had been selling straddles around 19,000, meaning he needed the index to stay near 19,000 or he stood to lose vast sums.

And while the characters of Nick and Lisa, his wife, are well realized, others are less thoughtfully developed, particularly when the film strays from the book’s account of events. Ron Baker, introduced in the film as head of derivatives trading in London (the book calls him head of the financial products group), is an adrenaline-charged buffoon, especially in a fictionalized motivational speech at the annual meeting in London (moved from New York, where it takes place in the book). Peter Norris, whose title is never given (he is the CEO), is an aloof opportunist who bawls when the bank finally goes bust, also in a fictionalized scene. Peter Baring, the bank’s chairman, is a pompous blueblood. The book notes that his famous statement, “...it was not actually terribly difficult to make money in the securities business,” was uttered in a meeting with Brian Quinn of the Bank of England. In the film, the comment is made by a smug Baring before a rapt audience at a dinner party, to thunderous applause.

But these problems are minor, owing mostly to a filmmaker looking for dramatic effect. In most ways, the film is far more satisfying than the book, with far more punch. The pace of the film is taut, the dialogue crisp, the acting—particularly McGregor and Anna Friel, who plays Lisa—terrific.

And most of the film’s wanderings from the book are winning. A dinner party scene in which Nick imagines himself telling his superiors about the 88888 account is quite funny, and the film’s love story, at times treated graphically enough to earn an R rating, is well-developed.

In a film so dominated by dialogue, Nick’s description of the continent of Asia says it all: “What’s good about this place is it’s not still full of pompous ex-colonials who think they were born to rule the world...Anyone can make it here.”

Derivatives Trading: Cinemax Style

The cinematic version of Rogue Trader begins with young Barings back-office clerk Nick Leeson being sent to Jakarta to straighten out a mess involving bearer bonds. After solving the problem—and meeting Lisa, who soon becomes Lisa Leeson—Nick is transferred to Singapore to become general manager of Barings’ Simex trading operation, focusing on Nikkei futures and options. Nick is tapped to run both the trading side of the business and the back-office settlement operation—a decision that would prove disastrous. Shortly after setting up shop, Nick creates an error account—choosing the number 88888 because a clerk says the Chinese consider eight a lucky number—to sort out the inevitable mistakes of an inexperienced trading operation. On one Friday afternoon, Nick is confronted with just such a gaffe. One of his young traders mistakenly sells 20 Nikkei futures rather than buying 20, creating a 20,000-pound hole in the balance sheet. Nick tells his immediate boss, Simon Jones, regional manager of the Southeast Asia division, about the problem, but Jones brushes it off, telling Nick to deal with it himself. Nick does, but not in a way Jones would have liked. On Monday, rather than immediately trading out of the position and taking the loss from Friday’s price, Nick keeps the position in the hope that the market will improve. The reverse happens, and Nick is forced to sell at a 60,000-pound loss to get out. Putting his back-office knowledge to work, Nick places the loss in the 88888 account. His plan: to trade out of the hole using Barings’ client accounts, diverting the profits to cover the error account. As long as the balance is zero by the end of the month, he reasons, no one will know the difference. Before long, he has run the 88888 account into a 10-million-pound hole. In a goofy cinematic contrivance, Nick, pounding a heavy bag at a gym, hatches his ultimate strategy to circumvent the balance sheet. He realizes that he can solve the problem of funding his growing initial margin payments by selling options. “That’ll generate commission in-gain,” he enthuses, “and will return the balance on the five-eights account to zero.” There’s one catch to the plan, however: Nick must generate huge business to keep up with the margin calls. Enter Pierre Beaumarchais (known as Philippe Bonnefay in the book), a Swedish investment banker and big-ticket player who falls into Nick’s lap at the perfect time. Soon Nick is doing big business, and by the end of 1993 he makes up the entire 10-million-pound loss in the 88888 account. Nick, now the biggest player at the Simex, resolves to kick his addiction to the 88888 account once and for all. But soon thereafter, Beaumarchais requests a big trade that Nick doesn’t fully understand. Without being sure he can pull it off, Nick guarantees Beaumarchais’ price and tries to “leg it” in order to keep the business from going to Societe Generale. The plan backfires, and Nick is forced to reopen the 88888 account. The downward spiral has begun. Later on, a back-office clerk notices a 7.78-billion-yen loss in the 88888 account—roughly $78 million—and Nick scrambles to cover his tracks. He tells the clerk to print a report showing that Simex owes Barings the sum, then requests more cash funding from London to cover his margin payments, which are becoming massive. Meanwhile, he begins lying to Simon Jones and the London office about the deal and the extent of the bank’s positions. By the end of 1994, Leeson is in deep trouble. While Nick’s losses grow, Lisa has a miscarriage. The event becomes a turning point: Nick decides that he’ll take an even more aggressive approach to get out of his mess. When a Coopers & Lybrand accountant preparing the 1994 year-end audit confronts Nick about the 7.78-billion-yen receivable from Simex, he concocts a wild story about an over-the-counter trade between Spear, Leeds & Kellagg (Kellogg in the book) and Barings. The accountant demands documentation, and Nick, adding forgery to his crimes, provides it, even arranging for a bogus bank transfer. Meanwhile, the positions in the 88888 account begin taking on a life of their own. The Kobe earthquake sends the Nikkei plummeting, causing Nick to lose more than 50 million pounds in a single day. Nick tries to hold on until February 24—bonus day. He’s been promised at least 350,000 pounds, and plans to get out of Singapore upon receiving the check. But the clock is working against him as his losses mount. On February 23, one day before he’s to receive his bonus, the Nikkei falls to 17,665 despite Nick’s frantic efforts to prop up the market. Nick realizes it’s over, having lost more than 300 million pounds all told. He and Lisa flee Singapore, only to be captured by German authorities after landing in Frankfurt the following Monday. The result of Nick’s rogue trading: Barings loses more than 800 million pounds as its positions crash, and the bank is bought by ING for $1. —R.H.

Since last fall’s spike in volatility, equity volatility swaps traders have shifted from pure plays to spread strategies and other relative-value trades.

By Nina Mehta

Many new derivatives products go through ups and downs as they build a track record. Compared with currency volatility swaps, which have been trading for about five years, equity volatility swaps have wider spreads and are less liquid, but their use has stepped up significantly since they began trading two and a half years ago, with some of the larger dealers now writing 100 or more trades a year.

Unlike currency volatility swaps, equity volatility swaps started out as a one-sided market, with clients, mainly hedge funds, selling volatility to dealers. There is now a healthy two-way flow, and—with implied volatilities in the market down since last fall—the market has seen an opportunistic shift to relative-value spread trades and strategies that slice and dice volatility exposures more closely.

“The assumption is that implied volatility is rich compared to historical volatility, so that a volatility seller has an edge.”

Equity volatility swaps made their debut as a substitute for options strategies. Volatility accounts traditionally used options—generally straddles—to make bets on volatility as an alternative to speculating on the direction a stock or index might take. An investor holding a call option on an index, for instance, may not expect the underlying index to go up, but may think there’s a profit to be made if the call option is cheap on an implied volatility basis, relative to where it should be trading.

The drawback with using options to trade volatility, however, is that dynamically hedging the exposure can be cumbersome and tricky. Hedge funds and other volatility accounts don’t have access to the level of options flow that dealers see; as a result, their pricing is less advantageous. Moreover, adjustments to futures hedges need to be made when the index shifts, producing replication risk—the risk that the hedge won’t correspond precisely to the underlying trade.

Since volatility swaps are based on annualized realized volatility at maturity, they are considered cleaner bets on volatility. “They’re easy to implement and track, and don’t require ongoing risk management of the options via delta hedging,” says one dealer who has been trading swaps for a year and a half. “People’s view of the equity markets and the markets’ risks have also changed, and people are now playing it in different ways—taking a speculative view on volatility, using the swaps as hedges and spreading one index against another.” Leon Gross, director of global equity derivatives research at Salomon Smith Barney, one of the largest volatility swaps dealers, adds that more investors are now doing relative-value trades such as the Dow Jones Industrial Average vs. the Standard & Poor’s 500. The indices, he explains, have the same implied volatility, but the S&P 500 is more volatile because its technology weighting keeps increasing; consequently, investors have been buying S&P volatility and selling Dow volatility.

Here’s how a volatility swap works. Let’s say a dealer sells a client a one-year volatility swap on the German DAX with a strike of 30 percent. This means that after one year, at maturity, if realized volatility is above 30 percent, the client will make money. If it’s right at 30 percent, no one pays anyone. And to the extent that it’s below 30 percent, the client will owe the dealer money. Each realized volatility point above or below the strike is multiplied by, say, $250,000—a standard multiplier that’s in the mid-range of what dealers quote—to yield the amount owed the client or dealer. This makes the volatility swap a linear play on realized volatility. If volatility in the above case turns out to be 34 percent, for instance, the client will have a net gain of 4 volatility points, which, multiplied by $250,000, yields a gain of $1 million.

If the client doesn’t want to be simply long volatility, however, it could sell the dealer volatility on, say, the FTSE 100 at 27 percent, with the same maturity. The result of such a long/short transaction would be a 3-volatility-point relative-value trade. That client would be betting that realized DAX volatility after one year will exceed realized FTSE volatility by more than 3 points. If realized volatility on the DAX at maturity is 34 and realized volatility on the FTSE is 30, for instance, the client will make 4 volatility points on the long swap and lose 3 on the short swap, resulting in a net gain of 1 point, or $250,000.

While spread strategies have increased in popularity over the last six months, the pool of swaps users hasn’t altered drastically over the last couple of years, according to one of Wall Street’s largest dealers. Customers are still those with natural volatility books to hedge—that is, convertible arbitrage accounts, professional volatility traders who are long volatility, and statistical arbitrage or mean-reversion accounts. Volatility, at least in theory, is a mean-reverting trade. “The assumption,” says the dealer, “is that volatility oscillates around a norm but that implied volatility is endemically rich compared with historical volatility, so that a volatility seller has an edge at any given point in time but especially in periods such as last fall, when implied volatility swung up from already high levels to extremely high levels.”

In addition to the usual players, volatility swaps are now sometimes used by portfolio managers benchmarked to an index, as a way to reduce the tracking error that can result when markets somersault. Dealers also acknowledge that the occasional bank and other non-hedge-fund pools of capital are now testing the volatility waters. An advantage of volatility swaps, writes Dean Curnutt, a marketer on the equity derivatives desk at Lehman Brothers and author of a recent research report on volatility swaps, is that they offer portfolio diversification since they are “generally uncorrelated with market direction.”

To reduce the effect of spikes in volatility, most swaps are based on equity indices instead of single stocks. In the U.S. market, swaps are typically written on the S&P 500, the DJIA, the Russell 1,000 and Nasdaq; in Europe, they tend to be written on the CAC 40, the DAX, the FTSE 100 and indices in some of the smaller markets such as Italy and Switzerland. Maturities run from three months to five or even seven years, although most trades occupy the one-to-three-year range—also to avoid unexpected geysers of volatility. A number of dealers now write one-month volatility swaps, but since such short-dated swaps have the potential to wreak havoc, customers are forced to pick up the tab through much larger spreads.

“Higher transaction costs are offset by the purity of the volatility position, the reduction in operational risk and the dealers’ advantaged position in the market.”

The primary cost associated with volatility swaps is the bid/ask spread, which, as a rule of thumb, is approximately double the spread in the straddle market, notes Neil Chriss, a vice president at Goldman Sachs Asset Management, who directs the research and volatility trading strategy at one of the firm’s hedge funds. “If the bid/ask spread in the S&P straddle market is 1,” he says, “meaning that if fair value is 30 we are able to sell at 29 1/2 or buy at 30 1/2, then the volatility swaps market would have a 2-volatility-point spread, meaning that we would be able to sell at 29 or buy at 31.” Nevertheless, adds Chriss, the higher transaction costs associated with swaps are “offset by the purity of the volatility position, the reduction in operational risk and dealers’ advantaged position in the market, which enables them to price volatility swaps more competitively.”

There are a number of ways to gain volatility exposure through swaps. The swaps can be based on cash or futures, and investors can trade volatility swaps or variance swaps. A volatility swap is based on the annualized standard deviation of an equity index, while a variance swap is the square of the annualized standard deviation. It’s easier for traders to hedge variance swaps, says Salomon’s Gross. “Some customers understand this and are more comfortable trading variance swaps, since they are more directly implied by the options market.” A few hedge funds, for instance, trade volatility using variance swaps exclusively. In addition, the bid/ask spread for variance swaps and for swaps on futures is tighter than it is for swaps on cash, although futures have an added element of volatility because of basis risk—the risk that the price of futures will deviate from the contract’s fair value. Some dealers are also willing to calculate realized volatility based on weekly rather than daily data, since some clients think weekly data give the market a chance to mean-revert during the week, thus resulting in lower volatility.

Recently, a number of dealers have seen an increase in the use of forward volatility swaps, which involve buying one maturity and selling another. “If a customer is long March and short December, that’s equivalent to being long a swap on implied volatility,” notes Gross. Capped volatility swaps are also options for clients with short volatility positions who are seeking to eliminate unlimited downside risk. For those customers, he adds, the peace-of-mind factor is similar to “shorting a stock and buying an out-of-the-money call as a hedge.”

There has also been some dealer talk about a volatility swaps variation that would allow retail investors to make a play on volatility with limited downside risk. Dealers who have had a hard enough time explaining their products to institutional investors no doubt wish them the best of luck.

Was this information valuable? Subscribe to Derivatives Strategy by clicking here!