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Risk management lessons from Long‐Term Capital Management
Author(s) -
Jorion Philippe
Publication year - 2000
Publication title -
european financial management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.311
H-Index - 64
eISSN - 1468-036X
pISSN - 1354-7798
DOI - 10.1111/1468-036x.00125
Subject(s) - risk management , term (time) , arbitrage , systemic risk , economics , actuarial science , event (particle physics) , economic capital , value at risk , financial economics , finance , business , human capital , financial crisis , physics , quantum mechanics , macroeconomics , economic growth
The 1998 failure of Long‐Term Capital Management (LTCM) is said to have nearly blown up the world’s financial system. For such a near‐catastrophic event, the finance profession has precious little information to draw from. By piecing together publicly available information, this paper draws risk management lessons from LTCM. LTCM’s strategies are analysed in terms of the fund’s Value at Risk (VAR) and the amount of capital necessary to support its risk profile. The paper shows that LTCM had severely underestimated its risk due to its reliance on short‐term history and risk concentration. LTCM also provides a good example of risk management taken to the extreme. Using the same covariance matrix to measure risk and to optimize positions inevitably leads to biases in the measurement of risk. This approach also induces the strategy to take positions that appear to generate ‘arbitrage’ profits based on recent history but also represent bets on extreme events, like selling options. Overall, LTCM’s strategy exploited the intrinsic weaknesses of its risk management system.