Sunday, November 18, 2012

When Genius Failed

WHEN GENIUS FAILED: The Rise and Fall of Long-Term Capital Management
Author: Roger Lowenstein, Publisher: Random House

(Summary of book based on book reviews)

Nobel prizes and billions of dollars don't always equal success

Long-Term's basic strategy was to bet on the eventual convergence between the prices of extremely similar assets.

As an example, if Nifty futures offered a long term contract, say 1 year, then the arbitrage will be between the 3 month and the 1 year futures contract. Sometimes, the difference between the two will be Rs 10/-, and sometimes it may be Rs 12/-. The idea was to use computer based analysis to buy when the difference was perceived to be less and sell when it increased.
Now, making Rs 2/- on two contracts is no fun. There is margin required on two contracts, and, transaction charges, so where is the money? The return is going to be marginally higher than the interest.
In principle, it was a low-risk strategy, with tiny returns on each trade.
LTCM started with $4 billion. Then they took on loans for $100 billion. On the 100 billion, they will make a small amount after payment of interest, but that amount will become large enough on their own investment of 4 billion. LTCM was earning 50% per year on its capital. The 104 billion was used as margin to take on derivatives trades as explained above. LTCM exposure in derivatives was $1.2 trillion.
Now, all of this was working because the trades were almost risk free. Note my use of the word 'almost'.
With this kind of financial leverage even the most minute market move against you can wipe you out several times over. Talk about financial weapons of mass destruction! This risk did not deter Long-Term, though.
Finally in 1998, Russia defaulted on its bonds- many of which Long-Term owned. This default stirred up the world’s financial markets in a way that caused many additional losing trades for Long-Term.
[As an example, a sudden event in India causes the near month futures to fall much more than the far month. If you are short the near month and long the far month, you are in trouble!]
By the spring of 1998, LTCM was losing several hundred million dollars per day. What did LTCM’s brilliant financial models say about all of this? The models recommended waiting out the storm.
That's true, bcause convergence between two similar products was bound to happen at some point. But, if one instrument suddenly went against LTCM while the other one did not go in favor, LTCM was saddled with markt o market losses, increased margin - all on the 1.2 trillion dollars of positions. Where was the money?
By August 1998, LTCM had burned through almost all of its $4 billion in capital. At this point LTCM tried to exit its trades, but found it impossible, as traders all over the world were trying to exit as well.
With $1.2 trillion dollars at risk, the economy could have been devastated if LTCM’s losses continued to run its course. After much discussion, the Federal Reserve and Wall Street’s largest investment banks decided to rescue Long-Term. The banks ended up losing several hundred million dollars each.
What became of Long-Terms founders? Were they jailed or banned from the financial world? No. They went on to start another hedge fund!

Reviews used to write this post:

1 comment:

Dinesh said...

Dear Sir,
Thanks for this thought provoking post.
With that kind of money at stake, money-management or rather effective risk management is very important.
I think it is very important to keep in mind a sudden change which can push the market quite a bit in either direction.
Thanks again.