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The Fall of LTCM
Transcript of The Fall of LTCM
Any questions? ` Summary of Events The Fall of Long Term Capital Management Helga Prochaska Introductory Video Arnold Villegas Laurie Ducruet David Forsberg Xue Qin (Catherine) Chengyu Kong (Kathy) Agenda Summary of Events
Risk Management Evaluation
Proscriptive Actions and Broader Consequences
Questions and Answers Lessons Learned Augustine (1995):
Avoiding the crisis
Preparing to manage the crisis
Recognising the crisis
Containing the crisis
Resolving the crisis
Profiting from the crisis Avoiding the crisis by measuring the risk correctly:
Carefully implement the VaR model
Do not only use recent history to measure risk
Combine VaR with stress-tests Diversify your portfolio so as to manage the risk properly:
Keep liquid positions
Have enough capital to survive
Take into account the other actors present in the market Recognising and Containing the crisis:
Anticipate the crisis
Take a decisive action if there is an eventual risk
Model again with the new parameters Proscriptive Actions Warren Buffett's attempt to buy out LTCM
Actual bailout worth $3.625 billion from creditors, investment banks and institution Broader Consequences Calls for more regulation
Massive extension of Federal Reserve responsibilities
The return of "Too Big to Fail" Class Questions 1. Was the LTCM crisis a "Black Swan" event or the result of a "Perfect Storm"? Some background....
The Black Swan is a 2007 book by Nassim Taleb, focused on extremely rare events that have never been encountered before (to the best of the observer’s knowledge) and in principle, cannot be anticipated.
The Perfect Storm is a 1997 book about a storm in the North Atlantic that took boats by surprise and killed 12 people in October 1991. It was the result of a conjunction of a storm that started over the United States, a cold front coming from the North, and the tail of a tropical storm coming from the South. All three types were known before and occur regularly, but their conjunction is very rare. 2. Would you have bailed out LTCM?
Consider this from numerous stakeholder perspectives Food for thought...
Stulz (2008) argues that LTCM did all that was expected of them and loss was an "unlucky draw" A couple of rued decisions Leverage:
1997: Returns not adequate
So gave back $2.7bn to investors
Potential returns would increase
But so too potential losses
Leverage prior to crisis approximately 25:1
Leverage during crisis >100:1 Liquidity:
1998: Returns diminishing
Needed to improve its risk profile
So chose to dump off less-profitable investments
Lost its most liquid assets
Further exposed to liquidity risk
Global liquidity dried up Cultural issues from outset:
Narcissism at LTCM (see Stein 2003)
Shaped socio-technical system
Led to collapse of the effectiveness of trading methodology
Three components of narcissistic organisation (Freud 1914/1953):
Members feel unique & special
Unconscious omniscience Model risks were realised:
VaR: parameter setting
VaR: assumptions not holding
Black-Scholes conditions not holding