So LTCM is not wrong?

Discussion in 'P1.T1. Foundations of Risk (20%)' started by qin841121, May 10, 2012.

  1. qin841121

    qin841121 Member

    I remember reading something about LTCM not in the wrong. They are simply unlucky people as for example there may be a 1% chance losing 100 billion and 99% chance earning 50 billion but they are just unlucky that the 1% unfortunate event happens.

    Anyone read anything like this before? Just want to clarify as I find this concept very interesting.
  2. Dmitrij

    Dmitrij Member

    The thing is, there are generally 2 possible scenarios:

    1) they calculated their exposures and risks more or less correctly, and decided to go into the trade. They got unlucky since disasters simply happen every once in a while.If they had a 1% risk per year, it could have been the case that 1998 was "one year out of hundred", similar to floods.
    2) they totally miscalculated their risks and exposures and entered into a trade based on false assumptions about probabilities of default etc. (for example about Russia).

    1 would be an error of judgment rather than a risk management failure. 2 is a risk management (and judgment failure) and is the most likely scenario.

    1 would be: I know a coin has 50% probability of landing heads, and 50% of landing tails. I am going to risk amount X.

    2 would be: I believe coin has a probability of 75% of landing heads and 25% of landing tails. Let's engage in this trade.
  3. Aleksander Hansen

    Aleksander Hansen Well-Known Member

    There were warning signs/red flags: they got squeezed from both sides in terms of liquidity. If they had big enough a capital buffer their convergence arbitrage (and the entire trade book) would ultimately have been profitable. They just could not afford to hold to maturity.
    In one sense they were unlucky - hard to forsee Russian default and so forth; albeit they did this in a systematic way over a fairly long period, thus it was an event which warranted a contingency plan and adequate credit lines and proper peak collateral exposure and potential future exposure analysis.
  4. Aleksander Hansen

    Aleksander Hansen Well-Known Member

    Put differently, banks routnely sell OTM options, indeed, it's usually a money machine. You'll make money most of the time. Yet, this strategy is in and of itself not sound if you're naked, or don't have hedges in place etc.
  5. jeff-1984

    jeff-1984 Member

    Aleksander you know where i can find a detailed article about LTCM's case to better understand it?
  6. Aleksander Hansen

    Aleksander Hansen Well-Known Member

    So there are actually several books published on the topic, AND a movie was made as well. I have not seen the movie myself but I heard it was pretty good.
    There is a Harvard Business School Case Study on it as well which tells part of the story [part of the case study is figuring out the "missing" pieces, but the case study contains an excellent summary and backdrop/context]. My PhD supervisor had us do it when I was doing my masters [so before I was admitted to the PhD program] as part of an advanced options pricing class. He elaborated further on the events following the case study (where we were writing some code to simulate some of the trades)

    I can't speak to the books or movie personally though. I would start out by checking what has been written by Bob and Myron on the topic (that is Robert Merton [but he just goes by Bob] and Myron Scholes)

    General tips on reading economics and finance
    • Be sure the person writing it has a finance or economics background, or a PhD in e.g. Physics but many years of business experience.
    • I have read some of the Feds writings (as well as the World Bank, IMF and OECD but found it, more often than not, to be highly biased and glorified their role.
    • Don't waste time on Congressional Committe findings or SEC/CFTC studies. They are so political and of such poor quality it makes Miss America contestants' answer to question seem reasonable in comparison.
    • Also avoid those with a political agenda, such as, e.g. Paul Krugman. Basically, do a google search on the writer to find out what their research, articles and any columns is about, and if they're well known it will state which way they are leaning on Wikipedia.
    • I would avoid the hard-core policy jocks, as well as the hard core Keynesians, but more moderate Keynesians who by and large leave their political views out of the writings are OK, just remember they are looking at the issue from a set of premises and models which color the outcome (such as Harvards N. Gregory Mankiew).
    • Also, I would suggest that you read about it both from an academician, as well as a business person. That will often give you a fuller picture and you are able to figure out what the contentious issues are since they often view things quite differently.
  7. coquin22

    coquin22 New Member

    @Jeff: pls try When Genius failed, from a financial jounalist:)
    not sure if it was tru but it was said that GS ppl had viewed and made a snapshot of LTCM position and made a huge a profit out of it...
  8. ShaktiRathore

    ShaktiRathore Well-Known Member

  9. bhar

    bhar Active Member

    What about the Amaranth episode and its bet on the oil markets ?

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