Ltcm

SURVEY - MASTERING RISK -10: Why risk management is not rocket science

Financial Times, Jun 27, 2000, 3,169 words

Why risk management is not rocket science

Summary

In 1996 and 1997 the hedge fund run by Long-Term Capital Management (LTCM)

had an unbroken run of success and established an unrivalled reputation in

managing financial risk, says Ren Stulz. In August 1998, however, Russia

defaulted on its debt, setting off a chain of unheard-of market movements that

proved disastrous for LTCM. Some say the moral of the story is that risk

management is flawed, since the fund's partners were experts in the discipline on

Wall Street and in academia. Here the author offers a different interpretation of

events.

The collapse of the hedge fund managed by Long-Term Capital Management

(LTCM) in 1998 was a stunning event. Roughly half the LTCM partners had finance

doctorates, most of them from Massachusetts Institute of Technology (MIT). Two

of its partners, Robert Merton and Myron Scholes, had won the Nobel prize for

research of which the cornerstone was a technique to hedge derivative risk. LTCM

also included a group of traders with considerable experience in the markets and

the leader of this dream team was a trader with an awesome reputation. Yet in a

matter of months the fund lost more than Dollars On and LTCM was accused of

seriously endangering the world financial system. Many have argued that this

collapse demonstrates that modern financial risk management techniques do not

work. Before turning to this issue, it is useful to review the history of LTCM up to

and including the collapse.

Where did LTCM come from?

In the 1980s and early 1990s, Salomon Brothers made billions of dollars through

its proprietary trading. Most of those profits came from its bond arbitrage group led

by John Meriwether. This group was created to take advantage of misvaluations of

securities with correlated risks by taking a short position in the overpriced...