Kites, planes and other high-flyers

Barings' Bankruptcy and Financial Derivatives
October 26, 1995

Peter Zhang must be commended for his courage in rushing to print a comprehensive review of the Barings saga, well before all the facts are fully known through legal proceedings.

If we were to look back at his book in two or three years' time with the added advantage of more knowledge, or even pull out a magnifying glass today, maybe we could find fault with the odd statement or apply a different interpretation to detail.

The value of this book, however, is primarily educational and not historical. Indeed it is a book of two halves: the educational one that stands well on its own and the historical or contextual one that is a necessary building block but has no great value per se.

His account of the crucial days appears to be secondhand or from media records, without any evidence of access to recall by the protagonists of those days, and the history of the Barings family is a cursory summary of what has already been printed. This does not matter, however, as it is enough to set the stage.

The educational part of the book is well and clearly written. But it could have been even easier to read, if the maths and the tables had been confined to appendices, using the space for additional visual explanations and graphs. The key concepts are all well explained. The analogies used are useful and colourful, albeit not always a 100 per cent fit.

Zhang defends the view that derivatives are an integral part of modern finance and not a perverted and perverting sideshow, a view he puts across very convincingly and one that I fully endorse.

He states very early on that "it is certainly true that neither the internationalisation nor the sophistication of the capital markets could have been possible without the rapid growth of futures and options exchanges".

I would have liked to see him develop the argument further and to demonstrate, or at least indicate, how current economic activity on a world scale would not be possible without the sophisticated financial infrastructure, based on derivatives, and how staring into the year 2000, the reliable management of pension funds, on which a large part of the population in the developed world will rely, is unlikely to be achievable without the use of derivatives.

Most useful things in life have an intrinsic natural beauty. Zhang captures the aesthetics of derivatives, when he explains the Vega measurement: "Volatility to options is what wind is to kites. Kites cannot fly without wind, and they tend to crash if there is too much wind. Options would not exist without volatility, and they cannot trade smoothly if there is too much."

You may find "beauty" is a surprising concept for finance, but it is an important one. Aesthetical value in a financial model is a reassuring feature. Truths are rarely ugly and overcomplication is often a proxy for lack of understanding.

The author is obviously keen to demystify futures and options for the general public, probably incurring the wrath of some academic colleague for the shorthand he usesfor such an endeavour. He is not only successful in this, but also sketches an understanding of the key markets, preparing well the canvas of his analysis of what probably went wrong.

This he captures beautifully in just one paragraph: "Although the 'game' involved was derivatives, the trader did not play according to the rule. Mr Leeson hardly had any training in derivatives, he was doing the transaction on his instinct."

There lies the root of the problem. It is the duty of management to "condemn" people to succeed, not to condemn them to fail. To condemn people to succeed demands establishing they have the skills for the job. You do not entrust a Boeing 747 to a child who learnt about aerodynamics from playing with a sling.

Equally Zhang is spot-on when he writes that "to reward performance is one thing, but it is quite another to pay very large bonuses based on trading profits with little or no link to the risk parameter or any long-term strategy of the firm. Barings traditionally paid 50 per cent of gross earnings, as bonuses to its employees, a rate higher than for most institutions."

The issue here is not greed, it is not even fairness - in absolute terms or in relation to staff and shareholders; it is about how the structure and philosophy of a bonus plan affects traders' behaviour, a subject on which many declare themselves experts, but one on which little or no scientific research has been done to date.

Overall, this is a book worth reading and certainly of great value for the uninitiated reader in understanding certain key aspects of modern finance.

Rudi Bogni is chief executive, Swiss Bank Coroporation, London. He is about to return to university for two years to study mathematics.

Barings' Bankruptcy and Financial Derivatives

Author - Peter G. Zhang
ISBN - 9810223331
Publisher - World Scientific
Price - £10.00
Pages - 166

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