LTCM, founded by the former head of Salomon Brothers John Meriwether in 1994 is a hedge fund that traded derivatives such as options and swaps using very complex mathematical models. The hedge fund employed two Nobel Prize winning economists Myron Scholes and Robert C. Merton. The fund had an initial capital of $1 billion pooled from interested investors. At the heart of its trading system lies a very complicated mathematical model for pricing options. This system, formulated by Scholes and Merton is supposed to take irrational human emotions away and introduce a systematic way of trading that will maximize profits based on historical statistics on the market. In other words, risk management is decided by their proprietary trading system based on quantitative analysis. Large investment banks and big name investors invested a total of $1.3 billion and LTCM’s first few operating years were very fruitful proving that mathematics takes away the risk generated by traditional methods of investing. In 1998, Long Term Capital Management raised the stakes confident that their quantitative methods should limit loses and borrowed $125 billion with only $5 billion in assets, this is big time leveraging.
LTCM specialized in selling call and put options that based on their quantitative methods would not be exercised. In other words, their system relies on steady and stable markets so that the strike prices of the options they sold would not be exercised. LTCM ignored the fact that option prices were so high indicating an imminent volatile market, but their complex math based trading box says otherwise, so they went ahead with the plan.
That same year in August 17 1998, Russia became a casualty of the Asian financial meltdown and suffered their own financial crisis; as a result, Russia was forced to devalue their currency, the Ruble. The volatility that LTCM thought was improbable was unfolding globally as Japanese and European bonds was under a major selling frenzy for the safety of US treasury bonds. The resulting volatility on the bond markets spilled through the equities markets and stock prices were wildly swinging in all directions. The options that LTCM thought would never be exercised were exercised as volatility in the stock market reached the strike prices of the options they sold. By August of 1998, Long Term Capital Management was bleeding in capital as it lost over $1.85 billion. As LTCM tried to contain loses by exiting most of their positions, this further triggered fear in the markets and volatility continued. The Federal Reserve took notice of this event and bailed out the hedge fund with $1 billion in four months. The efforts by the Federal Reserve did not stop the LTCM from losing a total of $4.6 billion. How can a group of intelligent people who formulated a mathematically sophisticated trading system fail to see this event from possibly happening? One factor is that the data contained in their formulas only goes back 5 years’ worth of historical figures. But the ultimate answer may lie on the fact that markets are not ran by numbers, behind the curtain of this seemingly complex trading arena is a group of people which are susceptible to irrationality. What LTCM failed to see is that human behavior cannot be translated into numbers.