Long Term Capital Management
From WilmottWiki
Long-Term Capital Management (LTCM) is a hedge fund famous for being founded by two of the discoverers of the Black-Scholes formulae, Myron Scholes and Robert Merton, later to become Nobel Laureates, together with John Meriwether, ex-Salomon bond arbitrage, and for the large losses they experienced over a very short period of time in mid 1998.
During 1998 LTCM took huge leveraged bets on the relative value of certain instruments. They were expecting a period of financial calm and convergence of first and emerging world interest rates and credit risk. Many of their trades had the same view of the world market. They were expecting a period of relative stability, with emerging markets in particular benefitting. In fact, the default by Russia on August 17th 1998 sent markets into a panic, investors fled to quality and many of the LTCM trades went wrong.
It was deemed too dangerous for LTCM to be allowed to fail completely, the impact on the US economy could have been disastrous. So the New York Federal Reserve organized, in September 1998, a bailout in which 14 banks invested a total of $3.6 billion in return for a 90% stake in LTCM.
It is possible that LTCM were using only rudimentary Value at Risk estimates, with little or no emphasis on stress testing. They estimated that daily swings in the portfolio should be of the order of $45 million. But this didn't allow for extreme market moves and problems with liquidity. In trying to reduce risks LTCM even sold off liquid assets, leaving the (theoretically) more profitable illiquid trades stay on their books.
Bibliography
- Lowenstein, R 2001 When Genius Failed: The Rise and Fall of Long-Term Capital Management. Random House
- Poundstone, W 2005 Fortune's Formula. Hill & Wang
