26.07.2022 / 08:08

Long-Term Capital Management (LTCM)

Financial Markets

Financial Market Losses

Hedge fund Long-Term Capital Management (LTCM) had all the ingredients to be the star of Wall Street: one of the most successful traders like John Meriwether, famous Nobel Prize winners - Myron Scholes and Robert Merton, and significant initial capital.

After the Asian crisis and Russian default on bonds and currency devaluation, flight-to-quality and liquidity in 1998 together with the high leveraged strategy of the fund, made it almost collapse. LTCM in 1997 managed around $7 billion when in September of 1998 this amount dropped to $600 million. As LTCM by the mid of 1998 was too big to fail, the Federal Reserve Bank of New York arranged a bailout of the fund, by banks that could be affected by the very likely collapse.

The numerous takeaways especially for risk management could be identified in aftermath of this story:

  • Legal Regulations should cover more financial institutions despite the number of their investors and their net worth

  • Models should have as input long enough historical data and their output should be taken deliberately and correctly interpreted

  • Limitations and assumptions of the models should be considered (for example prices are not always reflecting economic changes immediately)

  • Better stress-testing and "worst scenario" analysis

  • Different types of risks should be considered

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