Price Discovery during Periods of Stress:
Barings, the Kobe Quake and the Nikkei Futures Market*
Stephen Brown
New York University

Onno W. Steenbeek
Erasmus University

Abstract
This paper examines price discovery of Nikkei stock-index futures both on the
Osaka Securities Exchange (OSE) and the Singapore International Monetary
Exchange (SIMEX), around the Kobe earthquake in January 1995, and the collapse of Barings bank six weeks later.
First, we examine the effect of a shock to the economy on a securities market.
We study individual variables and conclude that the above-mentioned events did
have a large impact. Volume and volatility rise significantly after both events.
Interestingly, the earthquake does not have a large impact on the bid-ask spreadon SIMEX, while Barings’ collapse does seem to have an effect. An interesting
aspect of this paper is the fact that we investigate a financial product that is tradedsimultaneously on two markets. Prices on SIMEX are slightly higher throughout
the sample, indicating an impact of Leeson’s massive purchases on SIMEX, as
well as a perceived absence of systemic risk in the aftermath of Barings’ failure.
Second, we examine Leeson’s trading strategy more closely. We find evidencemonths before the actual collapse, that Leeson could be described as a ‘doubler.’
By continuously doubling his position, he tried to trade his way out of the mountain of losses. If you do recognize such a trader, you could take him out of themarket sooner, limiting systemic risk. An important aspect of doublers is that
their trading strategy produces normally distributed returns with a high mean foran extended period of time, followed by a very bad event. Among other things,
this has important consequences for the effectiveness of Value-at-Risk controls.

* We would like to thank the Osaka Securities Exchange, Mr. Naoto Watari in particular, and theSingapore International Monetary Exchange. Also, we would like to thank the Institute for Monetaryand Economic Studies of the Bank of Japan.
Please send all correspondence to: Dr. Onno W. Steenbeek, Erasmus University, Departmentof Finance, Room H14-15, P.O. Box 1738, 3000 DR Rotterdam, The Netherlands. Phone: +31-104081494, Fax: +31-10-4526399, E-mail: steenbeek@few.eur.nl

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1

Stephen Brown and Onno W. Steenbeek

Introduction

This paper examines the impact of the Kobe earthquake of 17 January 1995, andthe collapse of Barings bank on February 27th on trading activity in Nikkei stockindex futures both on the Osaka Securities Exchange (OSE) and the Singapore
International Monetary Exchange (SIMEX). These two events sent shockwaves
through international financial markets, and there were fears that the Barings
debacle would have serious systemic consequences.
The market for Nikkei futures is interesting in light of these events, because
the Nikkei index is the main indicator of Japanese stock market sentiment.
Moreover, losses on the Nikkei futures market were the main cause of the Barings
collapse. The job of Barings’ chief derivatives trader in Singapore, Nicholas
Leeson, was to arbitrage between the OSE and SIMEX and try to capitalize on
small price differences between the futures contracts. In reality, however, he wastaking massive long positions in Nikkei futures, financing SIMEX’ margin requirements by selling options and borrowing huge amounts of money from Barings’ headquarters in London. By the end of February, the losses had become toolarge and Barings bank went bankrupt.
The first aim of this paper is to analyse the performance of the Nikkei 225
futures market. One would expect a massive earthquake and the failure of a large
market participant to cause a dramatic change in the information asymmetries,
liquidity, depth and trading costs. We examine the individual market variables
that might have been affected by these two events. The variables considered are
the index value itself, its volatility, futures trading liquidity, transaction costs andmarket depth.
An interesting aspect of this paper is the fact that we investigate a financial
product, i.e. futures on the Nikkei 225 stock-index, which is traded simultaneously on the OSE and on SIMEX. Whenever a financial product is traded on two
different markets, uncoordinated regulation of those markets could lead to unintended and often unwanted side-effects. A system of strict daily price limits on
one of the two exchanges, for example, may lead to shifts in volume and volatility
even before the limits are hit (Berkman and Steenbeek, 1998).
Changes in other institutional features may affect the relative trading costs ofthe two markets in an unintended manner as well. In response to the events mentioned above, the exchanges independently changed margin requirements andimposed trading halts. The situation on the market for futures on the Japanese
Nikkei stock-index during the eventful period around the Kobe earthquake and thesubsequent collapse of Barings bank, provides us with an excellent opportunity to
study the question of whether the action taken by the exchanges was effective.
The second aim of the paper is to examine the trading strategy followed by
Nick Leeson more closely. We find evidence months before the actual collapse,that Leeson could be described as a ‘doubler.’ By continuously doubling his
position, Leeson tried to trade his way out of the mountain of losses, much likenaive players in a casino continuously double their position, because they think itPrice discovery during periods of stress411

is impossible that the ball for instance falls on black ten times in a row. We claim
that, using the proper information, it is possible to recognize a doubler such as
Leeson sooner. If you do recognize such a trader, you could take him out of themarket sooner, limiting systemic risk.
This paper is structured as follows. Section 2 provides information on the two
events and reviews literature on the effect of information shocks on securities
trading. Section 3 describes the institutional background of the Nikkei derivatives
market, the exchanges’ regulations to limit ‘excess’ volatility and the specificactions taken by the exchanges in response to the two events. Section 4 presents
the data and the methodology, followed by our empirical results in Section 5.
Finally, Section 6 concludes.

2

Background

2.1

The Kobe earthquake

In the early morning of January 17th, 1995, an earthquake with a force of 7.2 on
the Richter scale shook the Japanese city of Kobe, killing 4,500 people, leaving
15,000 people injured and more than 200,000 homeless. The total economic
damage was estimated to be approximately 6.9 trillion yen (about US$70 billion).
The Great Hanshin-Awaji Earthquake, as the shock was called, was the mostdestructive earthquake since the great Kanto-shock in 1923.
Analysts initially thought that the economic stimulus from reconstruction
would offset the immediate disruption to production. As a result, the Nikkei index
dropped only slightly in the three days following the quake. However, after threedays it became clear that government action would be limited and sentimentchanged dramatically. As a result, the Nikkei index dropped 1,055 points on
Monday, January 23rd. Figure 1 shows the Nikkei index over our total sample
period from 1 July 1994 until 1 July 1995.

2.2

The Barings collapse

On February 23rd, 1995, the Singapore office of Barings bank was not able to meet its
margin requirements on futures positions at the Singapore International Monetary
Exchange (SIMEX). On that day, Barings owed more than US$1 billion on financial
futures contracts traded through its Singapore office. The loss-making transactions
were made by Nicholas Leeson, who was the chief derivatives trader in Barings’
Singapore office. The majority of the futures contracts were based on the Japanese
Nikkei 225 stock index. These Nikkei futures are traded on the Osaka Securities
Exchange (OSE) as well as on SIMEX, and Leeson’s main assignment was arbitrage
trading. This arbitraging involves buying futures contracts on one market and simultaneously selling them on another, exploiting slight price differences. Profits are
small, and therefore trading volumes tend to be large. Still, the risks are low, because

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Stephen Brown and Onno W. Steenbeek

every long position on one exchange is offset by a short position on the other.

Figure 1: The Nikkei index
21000
Kobe quake

Barings collapse
Barings’
collapse

20000

19000

18000

17000

16000

15000

14000
07-94

08-94

09-94

10-94

11-94

12-94

01-95

02-95

03-95

04-95

05-95

06-95

07-95

Source: Datastream

What really brought down Barings bank were large unauthorized speculative
positions. The largest part of Leeson’s losses came from a massive long positionin Nikkei futures. Secondly, he had a large short position in futures on Japanese
Government Bonds (JGB’s), on which he ran large losses as well, because themarket was rising. Thirdly, Leeson built a position of short straddles1 in late 1994
to finance the margin on his futures positions. This straddle would have been
profitable as long as the Nikkei index remained within a band of ¥18,500 to¥21,000. Leeson tried single-handedly to support the market by buying a large
amount of Nikkei futures, expanding his long position in Nikkei futures to over
61,000 March contracts on February 23rd, or 60% of total open interest on SIMEX.
When the Nikkei dropped below ¥18,000 on February 23 rd, Barings was not able
to meet SIMEX’ margin calls. On Monday February 27th, Barings formally collapsed.
Systemic risk issues
Barings’ collapse did not initiate a collapse in securities prices or widespreadbankruptcies, despite grim predictions. Apparently, confidence in the banking
industry was not affected strongly. It was evident that one man had caused the1

A short straddle is a combination of a short call and a short put with the same exercise price.

Price discovery during periods of stress413

problems at Barings, and it was believed that this could not happen easily at otherbanks.2 Also, feared problems in the interbank market didn’t occur, because
Barings was relatively small and shortly after its demise it was taken over by the
Dutch ING group which took over all of Barings’ liabilities. The contribution of
the event to the international financial system is that it put a strong focus oninternal risk management systems, where many systemic problems originate. Also,
the damage to SIMEX’ reputation appeared to have been limited. Trading
volumes in all products remained high.
A factor that kept the Nikkei index volatile after February 27th, was the factthat fifteen Japanese banks had made a total of 67.7 billion Yen (US$720m) inloans to Barings Securities. Most of these loans were used to cover the cost of
Leeson’s margin requirements, because both the OSE and SIMEX require margin
payments to be paid in yen. The already fragile Japanese financial system comprises a relatively large part of the Nikkei index (approximately 20%) and uncertainty about the extent to which the new losses would be recovered, had a large
impact on the index.

2.3

Information shocks and price discovery: review of literature

The impact of new information on price formation has been subject of many
academic studies. Generally, the literature suggests that an information shock is
expected to induce an increase in volatility, at least temporarily. Higher volatility
would, in turn, lead to higher trading volume, wider bid-ask spreads and decreasing depth.
Volatility and trading volume
Widespread concern over volatility in securities markets has stimulated research
into the process by which information is impounded in securities prices. One
important question is whether investors react in a rational way to unanticipatedannouncements. Under the certain information hypothesis, Brown et al. (1988)
propose that volatility will increase following the announcement of any major
unanticipated event as the market responds to the incomplete information concerning the event. A number of papers have developed market microstructure
models that incorporate the different responses of informed and liquidity traders
to unanticipated announcements. Kim and Verrecchia (1991) conclude that postannouncement volume is a function of the absolute price change accompanying
the announcement and the extent to which the precision of information changes
across traders who are heterogeneously informed. Foster and Viswanathan (1993)
construct a model that relates unexpected news to higher trading volume andvolatility as a result of trading between informed and liquidity traders.

2
However, as became clear in the Summer of 1995, a single bond trader at the New York officeof Daiwa bank had accumulated losses of $1 billion over a period of 11 years.

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Stephen Brown and Onno W. Steenbeek

Transaction costs
Uncertainty in the market generally leads to higher transaction costs (wider bidask spreads) as well. Grossman and Miller (1988) discuss the issue in terms of the
supply of immediacy. The risk of delaying a trade creates a demand for immediacy, and the transference of risk to the market maker (or limit order provider) will
be reflected in the bid-ask spread. Transaction costs are strongly linked to liquidity and hence volatility shocks.
Information shocks and the trading system
An important difference between the OSE and SIMEX is the trading system. As
explained in more detail below, the OSE employs a computerized trading system,
while SIMEX relies on an open-outcry system. In periods of low information
intensity, trading volume is low and transactions are infrequent. As a result,information on the last trade is fairly old so that the limit order book informationof the electronic system is more updated and, hence, an important indicator ofmarket developments. At the same time, traders are relatively inactive so thatobservation of their behavior on the floor does not reveal much about their intentions and, thus, does not permit reliable predictions of their activities over the
next period. Finally, there is not much to be gained from conversation among
traders since new information to be evaluated is lacking. Hence, in a period of
low information intensity, the order book information of the electronic systemappears to offer more signals for predicting market developments than observation of traders on the floor.
In periods with much new information the danger of adverse selection increases. As the identity of the trading partner is unknown in an anonymous electronic system, there is little protection against adverse selection. Traders may
refuse trading, reduce their (volume of) limit orders in the order book, or shorten
the average time span for the display of an order in the order book. This will
reduce the information content of the order book. In a floor system, traders build
up a reputation for fair trading. Every trader knows the other traders so that
information trading is considered unfair although not ruled out. But there is some
sanctioning power of traders creating a barrier to adverse selection (Pagano and
Röell, 1993). Thebarrier becomes more important in periods of high information
intensity. Furthermore, observation of other traders becomes more informative. If,
for example, the same trader buys several times, then this indicates that he may
act on private information or that outsiders place large buy orders. In addition,body language of active traders is likely to reveal something about their next
trades although they may want to camouflage their intentions.
Massimb and Phelps (1994, p46) provide another reason for the relative
higher efficiency of an open-outcry system in a high volatility period. Calling asituation where there is great uncertainty about the equilibrium price a ‘fast
market,’ they write: ‘Open outcry handles fast markets surprisingly well because
a trader can change a bid or offer very quickly. A trader simply changes a handsignal and makes a brief verbal announcement, and his previous bid or offer isPrice discovery during periods of stress415

automatically and implicitly cancelled.’ They claim the risk for electronic
matching systems in fast markets is that the response time (elapsed time between
the trader pressing an action key and the system confirming or rejecting the action
on the trader’s screen) degrades as message traffic increases. Martens andSteenbeek (1997) find evidence for the prediction that the relative importance of
SIMEX increases when the market is volatile.
Doubling
Information from Leeson (1996) and others indicates that Leeson can be described as a ‘doubler.’ By continuously doubling his position, Leeson tried to
trade his way out of the mountain of losses, much like naive players in a casino
continuously double their position, because they think it is impossible that the ballfor instance falls on black ten times in a row. If you could recognize such a trader,
you could take him out of the market sooner, limiting systemic risk. A quote from
Leeson may illustrate our point:‘I felt no elation at this success. I was determined to win back the losses. And
as the spring wore on, I traded harder and harder, risking more and more. I waswell down, but increasingly sure that my doubling up and doubling up would pay
off ... I redoubled my exposure. The risk was that the market could crumble down,
but on this occasion it carried on upwards ... As the market soared in July [1993]
my position translated from a £ 6 million loss back into glorious profit.
I was so happy that night I didn’t think I’d ever go through that kind of tension again. I’d pulled back a large position simply by holding my nerve ... but
first thing on Monday morning I found that I had to use the 88888 account again ...
it became an addiction.’ (Leeson, 1996, pp.63-64).

3

Institutional background

Derivatives based on the Nikkei 225 stock-index are traded on a number of markets. The most important market is the Osaka Securities Exchange, followed by
SIMEX in Singapore. Contracts are traded in similar design, but there are anumber of differences.

3.1

The Osaka Securities Exchange

The OSE employs a continuous double auction trading system where buy and sellorders directly interact with each other through an order book. The order book is
managed by so-called nakadachi members, who solely function as middlemen intransactions between regular members. Nakadachi cannot trade for their own
account, nor can they accept orders from the public.3 A special feature of the OSE
trading system is that trading takes place in two daily sessions. The morning
3
On the Tokyo Stock Exchange, where a similar system is in use, the equivalent intermediary iscalled ‘saitori.’

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Stephen Brown and Onno W. Steenbeek

session (goba) lasts from 9:00 until 11:00 hours and an afternoon session (zenba)
from 12:30 until 15:00 hours. During these trading hours two types of auction
method are used. Each session is opened by a batched clearing process known as
itayose and followed by a continuous two-sided trading process called zaraba.
Itayose trading is performed by batching together all orders submitted prior to the
opening and determining the corresponding market clearing price. Once theopening price is established, the zaraba method is used to determine transaction
prices on a continuous basis during the remainder of the session. Generally, morethan 20% of daily volume is realized in the two itayose transactions. The marginalunexecuted orders remaining in the nakadachi’s order book determine the bid andask prices and the corresponding quantities. If two orders can be matched, then
the nakadachi member chooses as matching orders those with the best prices. If
there are a number of identical best bids or asks the trade is assigned according to
the time of entering the system, the first quote getting the trade. Large orders
exceeding the limit order of the quote will be split up over more quotes according
to price and time of entering the system. Information on transaction prices andvolumes is published instantaneously in the electronic system. A quote is valid
until it is explicitly withdrawn from the system.

3.2

The Singapore International Monetary Exchange

SIMEX uses a floor trading system in which dealers trade continuously throughopen-outcry. Like in Osaka, Nikkei futures are traded in two separate sessions,but the total trading day lasts 45 minutes longer: from 9:00 until 11:15 hours andfrom 12:15 until 15:15 hours.4 During these hours, traders publicly announce bids
and asks. If a trader finds a bid or ask attractive, the trader simply hits the bid ortakes the ask. The transaction price is then made public. Quotes are valid as longas ‘breath is warm.’ A trader can also request a quote, and then may accept thebest offer or refuse trading. When there are more traders with the same offer orask, the buyer or seller can choose with whom to trade. As there is no official
market maker, an official order book does not exist. Names of traders are notpublished by the exchange. This information is available only to the people on thefloor. Once a trade is executed, price information is immediately communicatedto the pit observers, who report the transaction over a worldwide electronic
communication system. Volume information is not registered simultaneously on
SIMEX: traders are required to report transaction size within 30 minutes after thetransaction is done (SIMEX, 1995). When trading is hectic, market makers willbe less willing to leave their spot on the floor frequently, so the lag between theactual transaction and its report to the floor clerks is likely to be longer.

4

time.

We follow Japanese time throughout the paper. In reality, Singapore is one hour behind Tokyo

Price discovery during periods of stress

3.3

417

Institutional differences and transaction costs

One of the obvious differences between the two trading systems is the limit orderbook. At OSE traders have insight into an anonymous limit order book, while at
SIMEX no official limit order book exists, but names and behavior of othertraders can be observed on the floor. Another major difference is the execution oforders. At OSE a large order can be matched in the electronic system with several
orders of the limit order book at different prices. On the other hand, at SIMEX
usually the number of contracts for which a quote is valid is fairly high, so that anorder is executed at one price only. The main institutional differences are summarized in Table 1.

Table 1 : Nikkei futures: Differences OSE and SIMEX*
OSE

SIMEX

Contract Unit

1000 times index

500 times index

Minimum fluctuation

¥10

¥5

Daily price limit

about 5%5% and 10% for 15 minutes

Customers margin

20% (5% cash)

10%

Members’ margin

15% (2% cash)

10%

Commission costs

0.080 (trading value ¥1bln.)

0.030 (trading value ¥1bln.)

Trading system

auctionopen outcry

Morning session

09:00 - 11:00

09:00 - 11:15**

Afternoon session

12.30 - 15:00

12:15 - 15:15*** The situation before the Kobe earthquake.

Source: OSE (1998) and SIMEX (1998)** Japanese time

Although a future that is bought in Osaka cannot be sold in Singapore andvice versa, arbitrage between SIMEX and the OSE effectively reduces pricedifferences. Whether an order is executed at a better price in one or the othersystem, depends on bid-ask spreads and price sensitivity to order volume in both
systems. If the spread is lower in the electronic system, but its price sensitivity toorder size is higher, then small orders are executed at a better price in the electronic system whereas large orders obtain a better price in the floor system.
Therefore, it is often argued that large investors get a better deal in dealer markets
than in auction markets (e.g. Pagano and Röell, 1992; De Jong, Nijman and Röell,1995).
Madhavan (1992) reaches a similar conclusion in his theoretical approach. For

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Stephen Brown and Onno W. Steenbeek

a continuous dealer system and a continuous auction system, with the latter not
being anonymous, price competition between dealers eliminates the ‘wedge’
between the transaction price and the expected value of the asset. Strategic behavior in auction markets, however, distorts prices and thus induces inefficiency.
If dealers can impose sufficient sanctions so that traders reveal their private
information in trading, then a separating equilibrium may be obtained. In an
anonymous market a pooling equilibrium is obtained. Hence the adverse selection
problem is allegedly weaker on the floor leading to lower bid-ask spreads andhigher trading volume. The latter implies that prices are based on a larger set of
information, making adverse selection even more unlikely (Glosten and Milgrom,
1985; Stoll, 1989). On the other hand, risk-averse traders can put very smallorders at various prices into the book to protect themselves against adverse selection whereas on the floor quotes are valid for larger order sizes (Glosten, 1994).
This allows for a smaller bid-ask spread in the limit order book so that smallorders would obtain a better price in the electronic system and larger orders
would obtain a better price on the floor.
Various studies have looked into total transaction costs of Nikkei futures
trading. Steenbeek (1996) finds that, although the explicit transaction costs aremuch higher in Osaka (see Table 1), total transaction costs are still lower. Should
regulation of futures trading be tightened further, however, SIMEX could well
become the cheapest market to trade Nikkei futures. Fremault and Bacha (1996)
estimate transaction costs over a number of years and conclude that transaction
costs on the OSE were generally lower, although in certain time intervals SIMEX
appeared to be cheaper. Fremault and Sandman (1996) study liquidity and efficiency on the Nikkei futures market during June, July and August 1993. Theyfind that trades on the OSE are less frequent, but larger in size and that pricevolatility measured over very short intervals is significantly lower on SIMEX.

3.4

The exchanges’ reply to unexpected events

Both exchanges employ trading rules aimed at limiting ‘excess’ volatility. The
OSE used to go very far in restricting trading in Nikkei derivatives. According toMiller (1993, p.7), ‘MOF saw index futures as a threat to its policies for discouraging selling—not just short-selling but any selling.’ Hence, futures trading on
the OSE was regulated strictly from the beginning. All rules seemed to be aimed
at reducing the spill-over effects of futures trading to the market for the underlying stocks. One of the rules was the comprehensive system of price limits. First,
Nikkei futures are not allowed to trade at a price outside the range of the previous
day’s closing price plus or minus the daily price limit. This daily limit depends onthe futures price level. Besides the system of daily price limits, there is an intraday price limit rule (‘speed bump’) on the OSE, called ‘special-quote’ system.
Where a similar system on the Tokyo Stock Exchange seems to work satisfactorily (see, for example: Lehmann and Modest, 1994 and Hamao and Hasbrouck,1995), the special quote system in Osaka was generally considered too strict. In

Price discovery during periods of stress419

February 1994, the rules were relaxed considerably. The daily limit was set at
about 5%, and the special quote system was triggered far less frequently.
SIMEX employs two circuit breakers which last for only 15 minutes after the
price limit has been hit. The first circuit breaker will take effect when prices reach
5% above or below the previous trading day’s closing price. Another 5%, or a
total of 10%, will spark off the second circuit breaker. Limits do not apply to thelast 30 minutes of trading, unless the 15-minute cooling period started just before.
There are also no limits for the last day of trading for the contract nearest to
expiry (SIMEX, 1995). It is clear that these rules are far less strict than the pricelimit rules on the OSE. During our sample period, these price limits were not hit.
Specific action in February 1995
Out of fear that Barings would not be able to meet margin calls, SIMEX almost
doubled margins two weeks after the Kobe earthquake, on February 3rd. On the
day of Barings’ collapse, SIMEX more than doubled margins again. The second
margin hike was aimed at dampening further trading in an already cautious market. After SIMEX had completed the process of unwinding the Barings position,
margins were narrowed, although not to their level of before February 2nd.
On the OSE, on the other hand, no strong formal action was taken in reply tothe events. As a matter of fact, margin requirements for both futures and options
were reduced on February 13th.

4

Data and methodology

4.1

Data

Our sample period covers the period starting from 1 July 1994, which is 6 months
before the Kobe earthquake until 1 July 1995, which is 4 months after the bankruptcy of Barings. Both from the OSE and from SIMEX, we received tick data on
Nikkei futures. The dataset from the OSE includes information on transaction
price and volume. However, the dataset does not include quotes. The dataset fromSIMEX contains all trades and quotes on all derivatives contracts traded on the
Nikkei index. The dataset does not include volume information. Apart from thetick databases, we use daily data containing information on prices, volume andopen interest for both exchanges.
A first look at the data reveals that the Nikkei futures market is very liquid.
Table 2 compares daily average trading value of Nikkei futures during four subperiods of our sample. Please note that the size of the OSE contract is twice aslarge as the SIMEX contract (see Table 1).

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Stephen Brown and Onno W. Steenbeek

Table 2 : Nikkei futures: Average daily trading activity

July - October ‘94
November - earthquake
earthquake - bankruptcy
bankruptcy - July ‘95

number of contracts

number of transactions

OSE

SIMEX

OSE

SIMEX

21575
25728
34345
25515

20098
21196
36547
25719

1365
1081
1697
1669

1362
1292
2007
1799

Information on the trading activities of Nick Leeson was collected by studying secondary material such as Leeson (1996) and Gapper and Denton (1997).

4.2

Methodology

In our analysis of the events in the beginning of 1995, we should make a distinction between the earthquake and the Barings failure. Of course, the Kobe earthquake is truly an unexpected information shock. It is more difficult, however, to
put an exact date on the impact of the difficulties encountered by Barings. The
market knew months before the actual collapse that Barings had built up a verylarge long position in futures.5 As SIMEX became suspicious, it doubled margins
on February 2nd, thereby increasing the cost of trading significantly. On February
27th, eventually, Barings formally went bankrupt.
We are interested in the impact of the events on a number of variables, and try
to find an answer to the question how an exchange should act if a similar situationarises in the future. One of the contributions of this paper to existing literature
comes from the fact that our dataset allows us to study the theoretical relationships described in Section 2 by looking at the two markets simultaneously.
Leeson was the dominant market player on SIMEX’ Nikkei futures market, but
his role was limited in Osaka. Therefore we can look at the effect of Leeson’s
actions on the pricing process in Singapore.
Volatility
As a first proxy of market variability we take the absolute daily returns on
SIMEX. However, recent studies show that much information is lost when relying
on daily closing prices. If on a trading day the return was zero, but within the day
5
The Financial Times quotes a US fund manager as saying: ‘The futures community has knownof this mega position for about the last three months. The position kept getting bigger and bigger
and bigger. Every time they tried to sell anything, the market would fall,’ in: Lapper, R., 1995, ‘The
Barings crisis: dealers puzzled over unusual futures strategy—Leeson’s trading logic,’ Financial
Times, 1 March 1995.

Price discovery during periods of stress421

prices fluctuated heavily, the absolute or squared return (equal to zero) is misleading. Other measures are then needed to capture the information that thetrading day was actually quite volatile. This provides a partial explanation for the
success of applying daily high and low, daily volume, number of price changes
and intraday returns. We follow Andersen and Bollerslev (1998) in taking the sumof absolute intraday returns as the measure for daily volatility. We calculate 16
15-minute absolute returns and add the absolute overnight and lunchbreak returns.
Next, we calculate volatility ratios similar to those in Schwert (1990) and lookat changes in relative volatility between the two markets. The first day of oursample serves as the base period. While the first period is held constant, we will
move the second 1-day period through time. The volatility ratio is calculated by
dividing the average absolute daily return of the second period by that of the baseperiod.
16

VOL* = å Ri

(1)

VOL = Ri(2)

g = VOL period 2 VOL period 1

(3)

i =l

where VOL*
VOL
Ri
g

= daily volatility using absolute intraday returns,= daily volatility using daily 3pm to 3pm returns,= return over interval i,= volatility ratio.

The process is repeated by moving period 2 through the dataset by one day,estimating g until the end of the dataset. Moving the second 1-day period throughtime enables us to compare future volatility periods relative to a point in time.
Finally, we calculate relative volatility between the OSE and SIMEX, using
intraday returns calculated over exactly the same intervals.
RELVOL = VOLOSE VOLSIMEX(4)

where RELVOL = relative volatility on the OSE vs. SIMEX
VOL= volatility measured using Equation 1.
Liquidity
As indicated in Section 4.1, the Nikkei futures market is very liquid. The OSE isthe dominant market and regained some market share after it relaxed trading rules
in February 1994. Using daily data, we examine to what extent the eventschanged the relative importance of the two exchanges in terms of trading volume.
As Martens and Steenbeek (1997) show, price formation is quicker and more

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Stephen Brown and Onno W. Steenbeek

accurate during hectic periods in SIMEX’ open-outcry system, while the OSE’s
automatic trading system functions better during periods of low volatility. We
calculate the relative trading activity during the periods of stress as the total
number of transactions during the periods that both markets were open. This way,
we avoid the data being influenced by trading halts.
RELTR = TR OSE TR SIMEX(5)

where RELTR = relative trading volume on the OSE vs. SIMEX
TR= daily number of transactions.
Depth
We calculate relative open interest, using Equation (6). One would expect the
OSE to become more important after the margin increases in Singapore.
RELOI = OI OSE OI SIMEX
where

(6)

RELOI = relative open interest on the OSE vs. SIMEX
TR= open interest at the close of trading.

Transaction costs: the quoted bid-ask spread
An important measure of the efficiency of an exchange is the implicit trading cost,measured by the bid-ask spread. For SIMEX, we measure the daily average
quoted bid ask spread for every trading day, based on all quote revisions. These
data were not available for the OSE.
Price effects
A final research question we try to answer is to what extent Leeson’s trading
activities actually influenced prices during the months leading up to Barings’
collapse. As indicated above, Leeson’s trades were mainly done on SIMEX,
where he single-handedly tried to support the Nikkei index by buying futures.6
The extent to which these activities have led to structural price differences between the OSE and SIMEX, provides us with a direct test of the efficiency of themarket.
We directly calculate the mean price difference of the two contracts at every
15 minutes of the trading day, provided that there is an observation on both exchanges. We test the following equation for two periods: three months before
Leeson’s last day on the job and three months after. The prices are based on thelast transaction in a given minute. We also test Equation (8), using the lagged
SIMEX price, because purchases by Leeson which lead to a positive price difference will be followed by arbitrage transactions between the OSE and SIMEX.
6
P. Martin and Financial Times writers, 1995, ‘The Barings Collapse: Blunders that bust thebank,’ Financial Times, 24 March 1995.

Price discovery during periods of stress

423

DIFFt = PtOSE - Pt SIMEX(7)LAGDIFFt = PtOSE - Pt -1SIMEX(8)

where DIFF
= price difference OSE vs. SIMEXLAGDIFF = price on OSE vs. lagged price on SIMEX= last price in minute t.
Pt
We split the sample up in five periods:
period 1 1/7/94 - 30/11/94 base period
period 2 1/12/94 - 16/1/95 heavy trading by Leeson
period 3 17/1/95 - 23/2/95 between earthquake and Leeson’s departure
period 4 23/2/95 - 10/3/95 period of uncertainty until ING takes over all
liabilities
period 5 11/3/95 - 1/7/95 stabilization
During period 1, one would not expect a significant price difference, since nomajor events took place and arbitrage takes care of price differentials instantly. In
period 2, Leeson purchased massive amounts of futures on SIMEX, trying to pushup prices. His actions may have caused price differentials to be more persistent.
During period 3, the market became much more volatile and price differentials
may have persisted for a longer period. Leeson stepped up his purchases on
SIMEX. Period 4 covers the interval during which SIMEX experienced the largest threat. If traders would have been concerned about the health of the exchange,
one would expect them to be prepared to pay a premium to hold Osaka futures.
Ito and Lin (1996) find some evidence for an increased systemic threat. Finally,
period 5 would be a period of stabilization, returning to a ‘normal’ market.
Doubling
Finally, we investigate the claim that Leeson could have been characterized as a‘doubler.’ If the doubling story is correct, we would expect to see an asymmetricresponse of SIMEX volume to price changes: prices go down, volume increases,
with the increase in volume a function of the number of downticks. However, if
prices go up we should not see such a relationship. Of course, we only haveaggregate data, but if it is true that Leeson was such a significant player, weshould see his trades in the aggregate data. We should realize that many studies
have shown a relationship between trading activity and volatility. However, we
expect to find a certain level of asymmetry between a falling and a rising market.
Formally, we test the following equation:

424

Stephen Brown and Onno W. Steenbeek

Vd SIMEX = a + b × PCHANGE + e d(9)= daily trading volume on SIMEX
where Vd
PCHANGE = the logarithmic close-to-close return= last price in minute t.
Pt
Since we will be using daily data, we split the sample into three periods ofapproximately 75 trading days each. Period 1 covers the interval between July 1st
and October 31st 1994, Period 2 between November 1st 1994 and February 23rd
1995, and Period 3 between February 23rd and June 30th 1995. The asymmetry is
expected to be strongest in period 2.

5

Empirical results

In this section we present the empirical results. Graphs for the individual variables are given below.
Volatility
Figure 2 plots daily volatility over the total sample period. Not surprisingly,
volatility increased dramatically following the earthquake. The jump happened
four days after the quake, because the market needed that amount of time toassess its impact. Figure 3 shows the Schwert-ratios based on return volatility on
SIMEX. We calculate two ratios: one (g1) based on daily 3 p.m. prices and one(g2) including intraday information. It is clear that ratio 2 follows a smoother path,but follows the same general path. Figure 4 presents relative volatility between
the OSE and SIMEX. Before the earthquake, volatility in Osaka is on average
10% higher than in Singapore. SIMEX volatility increases relative to the OSE
after the earthquake until the Barings bankruptcy, despite two SIMEX marginincreases and a margin decrease in Osaka.

425

Price discovery during periods of stress

Figure 2: Daily volatility in SIMEX Nikkei futures
12%

Barings’ collapse
10%

Earthquake

8%

VOL*
6%

4%

2%

0%
7-94

8-94

9-94

10-94

11-94

12-94

1-95

2-95

3-95

4-95

5-95

Figure 3: Volatility ratios
3.5

3.0

g1
2.5

2.0

g

g2

1.5

1.0

0.5

0.0
7-94

8-94

9-94

10-94

11-94

12-94

1-95

2-95

3-95

4-95

5-95

6-95

6-95

426

Stephen Brown and Onno W. Steenbeek

Figure 4: Relative volatility OSE vs. SIMEX
1.8
1.8

1.6
1.6

1.4
1.4

1.2
1.2

1.0
1.0

0.8
0.8

0.6
0.6

0.4
0.4

0.2
0.2

0.00
1-7
1-7

29-7
29-7

26-8
26-8

27-9
27-9

26-10
26-10

22-12
22-12

25-1
25-1

22-2
22-2

23-3
23-3

20-4
20-4

23-5
23-5

20-6
20-6

Table 3 shows that OSE prices are significantly more volatile before theearthquake, while the difference disappears after January 17th. This may indicatethat SIMEX’ margin hikes were successful in dampening volatility.

Table 3: Relative volatility OSE vs. SIMEXRELVOLTOTAL
period 1
period 2

Mean
1.01371.04050.9872

Std Dev
0.117
0.097
0.128

Cases
229
114
115

T-testt-value
1.78
4.45
-1.07

p-value
0.076
0.000
0.286

Liquidity
Figure 5 presents trading activity for Nikkei futures on SIMEX. Daily trading
activity clearly increases after the Kobe earthquake and remains at a higher level
through the rest of the sample period. Figure 6 shows the relative importance of
SIMEX during the first three months of 1995 proxied by the number of transactions. It appears that the OSE became relatively more important after the earthquake hit Kobe, which may at least partly be a consequence of the increasedtransaction costs on SIMEX due to the margin hikes.

427

Price discovery during periods of stress

Figure 5: Trading activity in SIMEX Nikkei futures
2500
2500
Barings’
collapse
Barings collapse

earthquake
KobeKobe
earthquake

daily
transactions
dailynumber
number ofoftransactions

2000
2000

1500
1500

1000
1000

500
500

0
7-94
7-94

8-94
8-94

9-94
9-94

10-94
10-94

11-94
11-94

12-94
12-94

1-95
1-95

2-95
2-95

3-95
3-95

4-95
4-95

5-95
5-95

6-95
6-95

Figure 6: Relative trading activity OSE vs. SIMEX (Jan.-March ’95)
2.50
2.50

2.00
2.00

RELTR
RELTR

1.50
1.50

1.00
1.00

Kobe
earthquake
earthquake

Barings
collapse
Barings’
collapse

.50
.50

.00
.00
4-1
4-1

11-1
11-1

19-1
19-1

26-1
26-1

2-2
2-2

9-2
9-2

16-2
16-2

23-2
23-2

2-3
2-3

9-3
9-3

16-3
16-3

24-3
24-3

31-3
31-3

428

Stephen Brown and Onno W. Steenbeek

Depth
While the OSE is clearly the most important market as far as open interest positions is concerned, the relative importance of SIMEX increased after the Kobe
earthquake in times of higher volatility (see Figure 7). This may partly be due tothe preference for open-outcry markets (see Section 2.3), but the increased trading
activity of Leeson may also have played a role. Barings’ position amounted to
60% of the total open interest position in SIMEX March contracts on February
23rd.
Transaction costs: the daily average quoted bid-ask spread
Figure 8 presents the daily average quoted bid-ask spread on SIMEX. It is clearthat the spread didn’t rise substantially after the earthquake. This was probably
due to the increased liquidity which kept spreads down. After Leeson had fledfrom his office on February 23 rd, the quoted spread started to rise and it remainedmuch higher throughout the rest of the sample period. After February 27th traders
took advantage of the forced sale by SIMEX of Leeson’s positions by widening
the bid-ask spread. It may also reflect the higher costs traders incurred because of
the raised margin requirements, for which they wanted to be compensated.

Figure 7: Relative open interest OSE vs. SIMEX
1.60
1.60
earthquake
Kobe earthquake
1.40
1.40

1.20
1.20

RELOI
RELOI

1.00
1.00

0.80
0.80
Barings
collapse
Barings’
collapse
0.60
0.60

0.40
0.40

0.20
0.20

0.00
0.00
7-94
7-79

8-94
8-94

9-94
9-94

10-94
11-94
12-94
10-94
11-94
12-94

1-95
1-95

2-95
2-95

3-95
3-95

4-95
4-95

5-95
5-95

6-95
6-95

Price discovery during periods of stress429

Figure 8: The daily average quoted bid-ask spread on SIMEX
0.050%
0.050%
0.045%
0.045%
0.040%
0.040%

0.030%
0.030%

bid-ask spreadbid-ask spread

0.035%
0.035%

0.025%
0.025%
Barings'
collapse
Barings’
collapse

0.020%
0.020%
earthquake
earthquake
0.015%
0.015%

Leeson’s
lastondayon
Leeson's
last daythe job
0.010%
0.010%

the job

0.005%
0.005%
0.000%
0.000%
1-7
1-7

1-8
1-8

1-9
1-9

1-10
1-10

1-11
1-11

1-12
1-12

1-1

1-1

1-2
1-2

1-3
1-3

1-4
1-4

1-5
1-5

1-6
1-6

Price effects
From the literature it appears that Leeson was an active trader in Nikkei futures
on SIMEX. Leeson (1996) shows that during specific periods, he actively tried tosupport the market, pushing prices on SIMEX up (see Figure 9). His desperateattempts to ‘double’ himself out of trouble increased in the final months of 1994
and, in particular the first two months of 1995.

430

Stephen Brown and Onno W. Steenbeek

Figure 9: Leeson and SIMEX Nikkei futures
21000
21000

Kobe
earthquake
Kobe earthquake
20000
20000

Leeson’s
last
Leeson's lastdayon
on thethe jobdayjob

futuresprice
futures price

19000
19000
buy, buy,
buy, buy
buy,
buy

18000
18000
buy, buybuy,buy
buy, buy
buy,
buy

17000
17000

16000
16000

15000
15000
10-94
10-94

11-94
11-94

12-94
12-94

1-95
1-95

2-95
2-95

3-95
3-95

Source: SIMEX tick database and Leeson (1996)

Table 4 presents the results of the T-test. The price difference is calculated as
the price on the OSE minus the price on SIMEX.
Over the whole sample, the SIMEX contract appears to be slightly but significantly more expensive than the OSE contract. As expected, price differences
during period 1 are insignificant. During period 2 price differences increase andbecome significant. After the earthquake, the price difference increases even more.
After Leeson’s departure, price differences decline, but prices in Singapore
remain higher than in Osaka. Traders apparently didn’t demand a discount to hold
SIMEX futures during this period of confusion. Finally, the price difference
increases slightly in period 5 and remains significant.

Price discovery during periods of stress

431

Table 4: Price difference between OSE and SIMEX
DIFF
TOTAL
period 1
period 2
period 3
period 4
period 5

Mean-0.3383-0.0071-0.5391-0.7086-0.4080-0.4775

Std Dev
6.654
6.061
5.325
6.666
8.364
7.320

Cases
56258
20438
6567
6781
2733
19739

T-testt-value-12.06
-0.17
-8.20
-8.75
-2.55
-9.16

p-value
0.000
0.876
0.000
0.000
0.011
0.000

Mean
-0.3427-0.0853-0.6778-0.7581-0.6605-0.3098

Std Dev
26.04219.028
14.59910.76712.38041.291

Cases
55020
19868
6300
6694
2710
19448

T-testt-value
-3.09
-1.33
-3.68
-5.76
-2.78
-1.05

p-value
0.002
0.183
0.000
0.000
0.006
0.295

LAGDIF
TOTAL
period 1
period 2
period 3
period 4
period 5

Doubling
Table 5 presents our results regarding the doubling activities of Nick Leeson.
During period 1, the relationship between price movements and trading volume
was weakly significant when prices declined, while they were completely insignificant when prices were rising. During period 2, the relationship becomessignificant in both cases, but much more strongly so when prices were moving
down. After Leeson left the market, the relationship remained. This may havebeen the result of a reversal in the causal relationship: Leeson’s positions were
unwound in a falling market.

432

Stephen Brown and Onno W. Steenbeek

Table 5: Asymmetries in volume-volatility relationships
period prices variableB
up return
695.2
C
15968.8
1
down return2482.0C
9677.7up return2854.3
C13400.2
2
down return6367.1C-1600.5
up return3178.6
C
10693.5
3
down return4890.6
C
1750.7SE B
1045.34637.31357.86122.11410.36015.5
1615.47576.2956.94557.01214.56343.4beta
t-value p-value
0.11
0.67
0.510
3.44
0.001
0.29
1.83
0.076
1.58
0.122
0.33
2.02
0.051
2.23
0.033
0.53
3.94
0.000
-0.21
0.834
0.47
3.32
0.002
2.35
0.024
0.53
4.03
0.000
0.28
0.784

R2
0.01

adj.R2
-0.01

0.08

0.06

0.11

0.08

0.28

0.27

0.22

0.20

0.28

0.26

period 1: 1 July – 31 October 1994
period 2: 1 November 1994 – 23 February 1995
period 3: 25 February – 30 June 1995

6

Conclusions

This paper examines price discovery of Nikkei stock-index futures both on the
Osaka Securities Exchange (OSE) and the Singapore International Monetary
Exchange (SIMEX), around the Kobe earthquake of 17 January 1995, and thecollapse of Barings bank on February 27th.
The first aim of this paper was to examine whether a shock to the economy
such as an earthquake and the failure of a large market participant cause adramatic change in the information asymmetries, liquidity, depth and trading costsin the market. We study individual variables and conclude that the abovementioned events did have a large impact. Volume and volatility rise significantly
after both events. Interestingly, the earthquake does not have a large impact on thebid-ask spread on SIMEX, while Barings’ collapse does seem to have an effect.
An interesting aspect of this paper is the fact that we investigate a financial
product that is traded simultaneously on two markets. Apart from examining theabsolute effect on individual variables, we are able to examine the relative effect.
Furthermore, we are able to examine the effectiveness of the response by the two
exchanges to the events. The changes in margin requirements on SIMEX seem tohave been only marginally effective. Prices on SIMEX are slightly higher throughout the sample, indicating an impact of Leeson’s massive purchases on SIMEX,
as well as a perceived absence of systemic risk in the aftermath of Barings’
failure.
The second aim of the paper is to examine the trading strategy of Nick Leeson
more closely. We find evidence months before the actual collapse, that Leeson

Price discovery during periods of stress433

could be described as a ‘doubler.’ By continuously doubling his position, Leeson
tried to trade his way out of the mountain of losses, much like naive players in acasino continuously double their position, because they think it is impossible thatthe ball for instance falls on black ten times in a row. We claim that, using theproper information, it is possible to recognize a doubler such as Leeson sooner. If
you do recognize such a trader, you could take him out of the market sooner,
limiting systemic risk.
An important aspect of doublers is that their trading strategy produces normally distributed returns with a high mean for an extended period of time, followed by a very bad event. Among other things, this has important consequences
for the effectiveness of Value-at-Risk controls.

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