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1 A Deeper Understanding of the Risks taken by LTCM
Although it is commonly thought that the trading positions taken by LTCM were predominantly convergence trades, this is in fact not true. As LTCM's capital base grew the need for additional returns on that expanded capital led it to undertake other trading strategies. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998 LTCM had extremely large positions in areas such as merger arbitrage (profitable when the mergers were consummated, unprofitable if they were not) and S&P500 options (net short long term S&P vol). In fact some market participants believed that LTCM had been the primary supplier of S&P500 gamma which had been in demand by US insurance companies selling equity indexed annuities products for the prior two years.
The profits from these trading strategies were generally not correlated with each other and thus normally LTCM's highly leveraged portfolio benefitted from diversification. However the general flight to quality in the late summer of 1998 led to a marketwide repricing of all risk and these positions then did all move in the same direction. As the correlation of LTCM's positions increased the diversified aspect of LTCM's portfolio vanished and large losses to its equity value occurred. Thus the primary lesson of 1998 and the collapse of LTCM for Value At Risk (VAR) users is not a liquidity one, but more fundamentally that the underlying covariance matrix used in VAR analysis is not static but changes over time.
2 References
- See 2000 in literature
- When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein , BooksEnthsiast.com
- Inventing Money: The story of Long-Term Capital Management and the legends behind it by Nicholas Dunbar , BooksEnthsiast.com
- How Salesmanship, Brainpower Failed at a Giant Hedge Fund by Michael Siconolfi , Anita Raghavan and Mitchell Pacelle Wall Street Journal, 16 November 1998
- The Failed Wizards of Wall Street by Peter Coy and Suzanne Woolley Business Week, 21 September 1998
