Long Term Capital Management hedge fund demise is an interesting case study for the students of financial markets. Many options traders use Black Scholes model in pricing options, then you must know that Myron S. Scholes was on the board of directors of Long Term Capital Management (LTCM). Twenty years ago, one bond-trading hedge fund grew from launch to over $100 billion in assets in less than three years. It saw yearly returns of over 40 percent. It was run by finance veterans, PhDs, professors, and two Nobel Prize winners. Everyone on Wall Street wanted a piece of their profits. But then the crash came. The crash was sudden and had the potential of bringing down the whole financial system. Federal Reserve Bank had to intervene itself to unwind the complex bets that had been placed by LTCM. Long-Term Capital was advised by finance quants, or quantitative analysts, who made a number of unsound, esoteric bets, including investments in interest rate derivatives. When Russia’s inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse.If you think you can make high return using high leverage using complex mathematical models, you should watch this Trillion Dollar Bet documentary below.
Game theory is very important when it comes to modelling the markets. The recent oil market crash can also be understood in a much better manner if we consider it in terms of game theory. You should also download this PDF that explains the lessons from the collapse of Long Term Capital Management.
Now why you need to understand the case of Long Term Capital Management. As a day trader you should understand how the stock market works and how the hedge funds can move the markets all of a sudden.
If you happened to be sitting behind a trading screen on Wall Street in late August and September 1998, you’ve likely been having some déjà vu over the past seven trading sessions. Intraday rallies continue to fail; there is a thundering stampede into Treasuries; rumors are buzzing about hedge funds in trouble; waves of selling pressure suggest wholesale dumping to meet margin calls.
If you needed any more evidence that there is some serious stuff going on behind the scenes on Wall Street, you got it in yesterday’s stock market open. Within minutes the Dow Jones Industrial Average had plunged 370 points in a panic selling spree as buyers went on strike. The Dow was down as much as 458 points in early afternoon before trimming its loses before the final bell to close at a minus 173 points.
It’s all so reminiscent of late August and September 1998 when the five year old hedge fund Long-Term Capital Management L.P., replete with two Nobel laureates on board feeding exotic mathematical formulas into computers, had levered up to the eyeballs in reversion-to-the-mean bets using massive amounts of money borrowed from the major firms on Wall Street. The reversion-to-the-mean thesis was based on the idea that the widened yield spread between risky securities and safer ones would narrow, i.e., revert to the mean….