The dangers of leverage

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Firms Involved

  • Long Term Capital Management (LTCM)

Year of the event

1998

Description of the case

LTCM was a hedge fund founded by John Meriwether, who previously headed the bond trading activities at Salomon Brothers. Meriwether gathered a lot of brilliant mathematicians and economics, among which Economics Nobel laureates Myron Scholes and Robert Merton, who were made famous by their pricing models for options[1]. During the first years of activity, LTCM generated impressive returns, exploiting arbitrage opportunities thanks to their superior models. However, as time passed, the arbitrages became scarcer, and LTCM engaged in more risky bets with a higher leverage. In particular, the fund put a huge bet on the convergence of corporate and government bond spreads. Their models, based on historical data, lead them to overwhelmingly underestimate the potential losses that the fund could face. In 1998, following the Russian bonds crisis, the bonds spread widened in Europe. In August of that year, LTCM lost up to $500m in one day. In a few months, the fund was on its knees, having lost $4.6bn. The governor of the Federal Reserve of New York gathered the Wall Street banks and had them bail out and liquidate the fund.[2]

Take-aways

  • Risk Management is paramount. It must be critically assessed. Proper stress testing is essential in order to avoid the caveats of historical data.
  • There are no such things as market neutral strategies

References

  1. Nobel in Economics 1997 awarded jointly to Robert C. Merton and Myron S. Scholes "for a new method to determine the value of derivatives"
  2. Roger Lowenstein, When Genius Failed