When Genius Failed: The Rise and Fall of Long Term Capital Management

Product Information

One key lesson is that highly leveraged entities may not have the luxury of long-term thinking, as unforeseen events can wipe them out. When Genius Failed recounts the story of Long-Term Capital Management (LTCM, a hedge fund founded in 1994 by a group of prominent Wall Street financiers and Nobel Prize-winning economists. Simply put, one could use it to hedge against losing a bet on the market, since the formula was able to work out how to place another bet in the opposite direction. But as long as the cheaper asset—the futures—rose by a little more (or fell by a little less) than did the bills, Eckstein’s profit on his winning trade would be greater than his loss on the other side. Bonds have a particular appeal to mathematical types because so much of what determines their value is readily quantifiable.

The core investment strategy of the company was then known as involving convergence trading: using quantitative models to exploit deviations from fair value in the relationships between liquid securities across nations, and between asset classes (i. LTCM had Myron Scholes (of Black-Scholes model: the famous options pricing model) and Robert Merton on its investment team, both of whom shared the 1997 Nobel Prize in Economics for a new method to determine the value of derivatives. com/book/669487/when-genius-failed-the-rise-and-fall-of-long-term-capital-management-pdf (Accessed: 14 October 2022).

Gradually, governments around the globe were forced to drop their restrictions on interest rates and on currencies. The earnings for partners in a hedge fund was taxed at the higher rate applying to income, and LTCM applied its financial engineering expertise to legally transform income into capital gains. And history has proven that banks raced to join funds like this because they simply didn't fully understand the risks. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited.

Despite its impressive pedigree, LTCM was unable to overcome the market forces that led to its eventual collapse in 1998. They are as intricate and immutable as the rules of a great religion, and it is no wonder that Meriwether, who kept rosary beads and prayer cards in his briefcase, found them satisfying. They used academic calculations and predictions as well as the latest computer software to recognize the opportunities and exploit them quickly.

Yet even in this love affair with hedge funds in general, LTCM stood out, both in terms of popularity and borrowing.

During panic, investors lose rationality and everyone runs to safety by dumping every asset they own. Most of our PDFs are also available to download and we're working on making the final remaining ones downloadable now. This came as a surprise to many investors because according to traditional economic thinking of the time, a sovereign issuer should never need to default given access to the printing press. No one cared much about what would happen to the fund but was forced to find a way to protect their assets.LTCM’s last weeks of self-sovereignty were marked by events that – according to LTCM – were almost impossible. By the end of the 1970s, firms such as Salomon were slicing and dicing bonds in ways that Homer had never dreamed of: blending mortgages together, for instance, and distilling them into bite-sized, easily chewable securities. The rise in risk aversion had raised concerns amongst investors regarding all markets heavily dependent on international capital flows, and this shaped asset pricing in markets outside Asia too.

Just for comparison, what this means in real-world terms: during the mid-1990s, LTCM was twice bigger than the second largest mutual fund in the world , and a staggering four times as large as its closest hedge fund rival! The result was that all their widely diversified investments, which were supposed to behave independent of each other, started losing money simultaneously. Investor Seth Klarman believed it was reckless to have the combination of high leverage and not accounting for rare or outlying scenarios. It’s a fair bet that you’ve probably never heard of Long-Term Capital Management (LTCM), a long defunct fund management company.As a consequence, when a much larger flight to liquidity occurred than had been anticipated when constructing its portfolio, its positions designed to profit from convergence to fair value incurred large losses as expensive but liquid securities became more expensive, and cheap but illiquid securities became cheaper.