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The fund Long Term Capital or what happens when the wrong genes? |
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Saturday, 20 September 2008 |
Long Term Capital Management (LTCM) notes one of the most interesting pages in the recent history of Wall Street. Great rising and the subsequent collapse of hedge fund continue to be subject of discussion in the financial world. But the history of LTCM affect many more areas of human activity and poses important questions about human nature and the way we think.
What distinguishes the collapse of LTCM than that of many other funds is that its board, and wonder, had gathered at the brightness of the brains of Wall Street and at the same time - lights in science. LTCM was founded in 1994 by legendary trader then Bonds Meriuedar John, who is also former vice president of Salomon Brothers. Meriuedar attract Mayran Skols and Robert Marton, who are winners of the Nobel Prize for economics. Skols with already deceased Fisher Black (and with the participation of Marton) create a model for evaluating the options - Black-Skols model. At that time Skols is perhaps the most famous financial and market expert and Meriuedar is one of the experts on Wall Street.
Raising of LTCM coincided with improvement in the Wall Street to the so-called quantitative (quantitative) and analysts' abandonment 'of quality analysts. Hedge funds and big investment banks are starting to recruit doctors in physics and mathematics. He began to rely more and more sophisticated mathematical models that suggest the opening up of profitable positions. Many of the "quality" (qualitative) analysts are replaced by sophisticated automatic investment programs.
Statistics and mathematics began to reign on Wall Street.
What invested quantitative analysts?
The basis of the logic of quantitative analysis appearing somewhat arrogance of scientists. The argument is: because the human brain is not a perfect machine in the assessment of risk and return, it must have moments in which the market is undervalued or un-value given tools that will later be returned to their real values. So "off" on Wall Street with mathematicians and physicists were somewhat understandable.
Quantitative analysts appeared with market-neutral strategies that guarantee profits regardless of the direction in which the market will bear. These are called. arbitration strategies that guarantee profits regardless of what happens. Based on historical information tones and modern statistical methods such as analyzer determines that the normal difference between two financial instruments (such as two types of bonds) is X points. Automated trading system monitors thousands of such financial instruments simultaneously and where the difference between bonds of our example increase of X 1 point, the system opens a long position in a cheap bond and short the more expensive. Thus, regardless of where the market takes Bonds, if spread between the two instruments again return to X points to analyzer will realize a profit of 1 point.
Along with these arbitration deals are made and many hedged against "all" options - such as currency risk, to change rates, etc..
What makes quantitative analysts to believe that the spread between the two instruments will return to "normal" levels?
The answer to this question lies in the historical details. Financial markets and other human activities are affected by the final number of variables. So if you have a large enough sample (eg price information from more than 20 years), then a statistician can with great precision to determine the average spread between the two instruments and to determine what is the likelihood of spread to return to average levels.
The method is similar to what insurance companies do. Based on past specify details such as what is the likelihood that a person dies of an age in a history and thus determine what should be the value of the insurance policy.
Everything seems very logical and Wall Street began to leave earlier specialists as George Soros and Jim Rogers, which defines, in which direction the market will go, what will be traded gold and oil, or whether British pound was derogate or overstated.
What quantitative analysts as LTCM offer is apparently secure way to big profits.
Initial gains of LTCM are enormous. The average return on the fund is over 40 percent during its first years. Equity of the company is just over 1 billion dollars in 1994 in the next few years the capital came to over 4 billion dollars. Interestingly, many of the managers and investing their money in the fund.
Because light volatility of the market profits are safe, but not great. This, together with the great popularity of the fund and star reputation on board its rapidly increasing its assets. LTCM began to deal with large sums, which reaches 30 to 1.
Profits continue to grow tearing. Asked how will describe the activities of LTCM, responsible: "We are a giant vacuum cleaner that collects cent of all financial markets in the world. LTCM appear as a giant market regulator, which opens position whenever the market made a "mistake" and not take "as needed". Then he quickly returned to "normal" levels, and LTCM gathers several percentage points of the percentage. It looks like the Board of LTCM indeed revealed the secret of financial markets and has fulfilled the dream of all scientists. Or so it shall be deemed to 1997
Beginning of the end: What went wrong?
In 1997 began the Asian crisis. Bank of Japan to Thailand go bankrupt. Prices of real estate on the continent to demolish. This leads to an increase in spreads on bonds. Nobel laureates models of LTCM show that the markets will soon return to normal conditions. LTCM continued to hedge against. Large spreads seem time for opening positions to be very profitable over time.
A year later, however unthinkable happens. Russia announced a moratorium on payments on its foreign debt. Investors are beginning to abandon risky assets and to buy U.S. government securities. Spreads between risk and non-risks bonds rose well above normal levels. Two crises, independent from each other, occur simultaneously. Market participants are breaded and start selling pace with irrational risk assets. The models of LTCM does not provide for such irrationality of the market. Predictions of mathematical models of LTCM is that the largest possible daily loss was 50 million dollars. Some days they recorded losses of more than 100 million dollars, with little news from Russia after their daily loss exceeds 500 million dollars.
Due to the large fund such liveradge fact almost deleted the entire capital of the company and LTCM before bankruptcy. Start negotiations with the Federal Reserve and several private banks to support the fund. Fears are that forced by its creditors LTCM would have to sell financial assets that will significantly lower the stock and this may cause bankruptcies of other smaller funds and to unleash so snowslip to create big problems for the financial system. With the assistance of private capital LTCM was purchased and liquidated later with a small profit for buyers of the fund.
Conclusion
The reason for the bankruptcy of the company is not that its Board of really ingenious people do not have any crisis. Yes, there is expected to do so. The problem is that certain of them likely to happen was not enough large. After the collapse of the fund shows that mathematical models Skols and Marton are providing "worst option, which was only 60 per cent of what really happened. Explained in simple, Skols, Marton and are Meriuedar betting that lightning never strikes twice in the same place. What happened but at the end of last century was the equivalent of "perfect storm" - many things go wrong at once. |
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