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LTCM’s Analysis of Risk Management. February 28, 2002 Frank Burke Larry Kissko Gurkan Salk Heather King. Agenda. LTCM Background Swap Spread Trading Strategy Project Analysis Comparison/measurement of LTCM’s Risk Assessment

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ltcm s analysis of risk management

LTCM’s Analysis of Risk Management

February 28, 2002

Frank Burke

Larry Kissko

Gurkan Salk

Heather King

agenda
Agenda
  • LTCM Background
  • Swap Spread Trading Strategy
  • Project Analysis
    • Comparison/measurement of LTCM’s Risk Assessment
    • Discussion on return and spread distribution, calculated implied std deviation
    • Estimate of LTCM’s Value-At-Risk
    • Proxy Tests
  • Take-aways
ltcm background
LTCM Background
  • August 21, 1998, fund lost $550m mostly from swaps spreads and equity volatility bets.
    • LTCM believed this event would occur 1 in every 800 trillion years (or an 8.3 std dev move).
    • Swap spreads shot up from 60 bps to 80 bps intraday vs. an average daily move of 2 bps
  • LTCM’s swap position represented 2.4% of global swap market in December 1997
  • Leverage ratios varied from 28:1 to a high of 55:1 in late 1998
ltcm trading strategy
LTCM Trading Strategy

We focused on of one of LTCM’s biggest trades:

  • Swap Spread Relative Value Trade
    • Swap spread – difference between the fixed rate on a fixed-for-floating swap and the yield on a coupon-bearing Treasury bond of comparable maturity
    • Speculative strategy that spread would converge to its historical mean
    • Long swap/short the treasuries (in 1998)
  • Crisis: Aug 21, spreads spiked 21 bps intra-day
project analysis
Project Analysis
  • Parametric VAR – assumes normal distribution
  • Historical VAR – based on actual data distribution
  • Proxy search – difficult to find a strong correlation
    • BAA- 10 year treasury
    • AAA- 10 year treasury
    • MBS - 10 year treasury
  • Forecasted daily variance

Value At Risk – defined as the expected maximum loss over a target horizon within a given confidence interval

value at risk var
Value at Risk (VAR)
  • Principal measure of risk at LTCM
  • LTCM parametric VAR measure
    • Capital (assume $1b) x daily std dev of returns (.02) x std dev of required confidence interval (3 = 99.85% 1-tail)
    • $1.0b x 2% x 3 = $60,000,000
  • Our historical VAR measure
    • $ 1.0b x 9.5238% = $95,238,000
take away thoughts
Take-Away Thoughts
  • VAR not necessarily suspect – correct inputs are critical
  • Cannot blindly apply normal distribution
  • Dig into your data
  • If data is not complete consider:
    • Developing a risk proxy
    • Assuming fatter tails in distribution (Student’s T curve)
appendix charts
Appendix - charts

August 21, 2002

references
References
  • Jorion, P., 2000 Risk Management Lessons from LTCM
  • Kolman, Joe, 1999, “LTCM Speaks”, Derivatives Strategy (April) p.12-17
  • Lewis, Michael, 1999, “How the Egg-Heads Cracked” New York Times Magazine, January 24, p 24-77
  • Anonymous, 1998, “Too Clever By Half”, The Economist Magazine, November 14
  • Whaley, Robert, 2001, “Derivatives” Class Presentation
  • Scholes, Myron, 2000, “Crisis and Risk Management- The Near Crash of 1998”, AEA Papers and Proceedings Vol 90 No. 2, May.
  • Bloomberg – Swap spread data