Long-Term Capital Management

Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm[1] based in Greenwich, Connecticut that used absolute-return trading strategies combined with high financial leverage. The firm's master hedge fund, Long-Term Capital Portfolio L.P., collapsed in the late 1990s, leading to an agreement on September 23, 1998, among 16 financial institutions—which included Bankers Trust, Barclays, Bear Stearns, Chase Manhattan Bank, Crédit Agricole, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Paribas, Salomon Smith Barney, Société Générale, and UBS—for a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.[2]

LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".[3] Initially successful with annualized return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year, in 1998 it lost $4.6 billion in less than four months following the 1997 Asian financial crisis and 1998 Russian financial crisis, requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.

Long-Term Capital Management
IndustryInvestment services
FounderJohn W. Meriwether
Defunct1998 private bailout arranged by U.S. Fed; 2000 dissolution
HeadquartersGreenwich, Connecticut
Key people
Myron S. Scholes
Robert C. Merton
John Meriwether
ProductsFinancial services
Investment management


LTCM Partners
John W. Meriwether Former vice chair and head of bond trading at Salomon Brothers; MBA, University of Chicago
Robert C. Merton Leading scholar in finance; Ph.D., Massachusetts Institute of Technology; Professor at Harvard University
Myron S. Scholes Co-author of Black–Scholes model; Ph.D., University of Chicago; Professor at Stanford University
David W. Mullins Jr. Vice chairman of the Federal Reserve; Ph.D. MIT; Professor at Harvard University; was seen as potential successor to Alan Greenspan
Eric Rosenfeld Arbitrage group at Salomon; Ph.D. MIT; former Harvard Business School professor
William Krasker Arbitrage group at Salomon; Ph.D. MIT; former Harvard Business School professor
Gregory Hawkins Arbitrage group at Salomon; Ph.D. MIT; worked on Bill Clinton's campaign for Arkansas state attorney general
Larry Hilibrand Arbitrage group at Salomon; Ph.D. MIT
James McEntee Bond-trader
Dick Leahy Executive at Salomon
Victor Haghani Arbitrage group at Salomon; Masters in Finance, LSE

John W. Meriwether headed Salomon Brothers' bond arbitrage desk until he resigned in 1991 amid a trading scandal.[4] According to Chi-fu Huang, later a Principal at LTCM, the bond arbitrage group was responsible for 80–100% of Salomon's global total earnings from the late 80s until the early 90s.[5]

Myron Scholes 2008 in Lindau Robert C. Merton
Myron S. Scholes (left) and Robert C. Merton were principals at LTCM.

In 1993 Meriwether created Long-Term Capital as a hedge fund and recruited several Salomon bond traders—Larry Hilibrand and Victor Haghani in particular would wield substantial clout[6]—and two future winners of the Nobel Memorial Prize, Myron S. Scholes and Robert C. Merton.[7][8] Other principals included Eric Rosenfeld, Greg Hawkins, William Krasker, Dick Leahy, James McEntee, Robert Shustak, and David W. Mullins Jr.

The company consisted of Long-Term Capital Management (LTCM), a company incorporated in Delaware but based in Greenwich, Connecticut. LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch.[9]

Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual funds, as established by the Investment Company Act of 1940—funds which accepted stakes from 100 or fewer individuals with more than $1 million in net worth each were exempt from most of the regulations that bound other investment companies.[10] In late 1993, Meriwether approached several "high-net-worth individuals" in an effort to secure start-up capital for Long-Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments and later the Italian central bank. The bulk of the money, however, came from companies and individuals connected to the financial industry.[11] By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.[12]

Trading strategies

The core investment strategy of the company was then known as involving convergence trading: using quantitative models to exploit deviations from fair value in the relationships between liquid securities across nations and asset classes. In fixed income the company was involved in US Treasuries, Japanese Government Bonds, UK Gilts, Italian BTPs, and Latin American debt, although their activities were not confined to these markets or to government bonds.[13]

Fixed Income Arbitrage

Fixed income securities pay a set of coupons at specified dates in the future, and make a defined redemption payment at maturity. Since bonds of similar maturities and the same credit quality are close substitutes for investors, there tends to be a close relationship between their prices (and yields). Whereas it is possible to construct a single set of valuation curves for derivative instruments based on LIBOR-type fixings, it is not possible to do so for government bond securities because every bond has slightly different characteristics. It is therefore necessary to construct a theoretical model of what the relationships between different but closely related fixed income securities should be.

For example, the most recently issued treasury bond in the US – known as the benchmark – will be more liquid than bonds of similar but slightly shorter maturity that were issued previously. Trading is concentrated in the benchmark bond, and transaction costs are lower for buying or selling it. As a consequence, it tends to trade more expensively than less liquid older bonds, but this expensiveness (or richness) tends to have a limited duration, because after a certain time there will be a new benchmark, and trading will shift to this security newly issued by the Treasury. One core trade in the LTCM strategies was to purchase the old benchmark – now a 29.75-year bond, and which no longer had a significant premium – and to sell short the newly issued benchmark 30-year, which traded at a premium. Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued. If the coupons of the two bonds were similar, then this trade would create an exposure to changes in the shape of the yield curve: a flattening would depress the yields and raise the prices of longer-dated bonds, and raise the yields and depress the prices of shorter-dated bonds. It would therefore tend to create losses by making the 30-year bond that LTCM was short more expensive (and the 29.75-year bond they owned cheaper) even if there had been no change in the true relative valuation of the securities. This exposure to the shape of the yield curve could be managed at a portfolio level, and hedged out by entering a smaller steepener in other similar securities.

Leverage and Portfolio Composition

Because the magnitude of discrepancies in valuations in this kind of trade is small (for the benchmark Treasury convergence trade, typically a few basis points), in order to earn significant returns for investors, LTCM used leverage to create a portfolio that was a significant multiple (varying over time depending on their portfolio composition) of investors' equity in the fund. It was also necessary to access the financing market in order to borrow the securities that they had sold short. In order to maintain their portfolio, LTCM was therefore dependent on the willingness of its counterparties in the government bond (repo) market to continue to finance their portfolio. If the company was unable to extend its financing agreements, then it would be forced to sell the securities it owned and to buy back the securities it was short at market prices, regardless of whether these were favourable from a valuation perspective.

At the beginning of 1998, the firm had equity of $4.7 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt-to-equity ratio of over 25 to 1.[14] It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

John Quiggin's book Zombie Economics (2010) states, "These derivatives, such as interest rate swaps, were developed with the supposed goal of allowing firms to manage risk on exchange rates and interest rate movements. Instead, they allowed speculation on an unparalleled scale."[15]

Secret and opaque operations

LTCM was open about its overall strategy, but very secretive about its specific operations, including scattering trades among banks. And in perhaps a disconcerting note, "since Long-Term was flourishing, no one needed to know exactly what they were doing. All they knew was that the profits were coming in as promised," or at least perhaps what should have been a disconcerting note when looked at in hindsight.[16]

Opaqueness may have made even more of a difference and investors may have had even a harder time judging the risk involved when LTCM moved from bond arbitrage into arbitrage involving common stocks and corporate mergers.[16]

UBS Investment

Under prevailing US tax laws, there was a different treatment of long-term capital gains, which were taxed at 20.0 percent, and income, which was taxed at 39.6 percent. The earnings for partners in a hedge fund was taxed at the higher rate applying to income, and LTCM applied its financial engineering expertise to legally transform income into capital gains. It did so by engaging in a transaction with UBS (Union Bank of Switzerland) that would defer foreign interest income for seven years, thereby being able to earn the more favourable capital gains treatment. LTCM purchased a call option on 1 million of their own shares (valued then at $800 million) for a premium paid to UBS of $300 million. This transaction was completed in three tranches: in June, August, and October 1997. Under the terms of the deal, UBS agreed to reinvest the $300 million premium directly back into LTCM for a minimum of three years. In order to hedge its exposure from being short the call option, UBS also purchased 1 million of LTCM shares. Put-call parity means that being short a call and long the same amount of notional as underlying the call is equivalent to being short a put. So the net effect of the transaction was for UBS to lend $300 million to LTCM at LIBOR+50 and to be short a put on 1 million shares. UBS's own motivation for the trade was to be able to invest in LTCM – a possibility that was not open to investors generally – and to become closer to LTCM as a client. LTCM quickly became the largest client of the hedge fund desk, generating $15 million in fees annually.

Diminishing Opportunities and Broadening of Strategies

LTCM attempted to create a splinter fund in 1996 called LTCM-X that would invest in even higher risk trades and focus on Latin American markets. LTCM turned to UBS to invest in and write the warrant for this new spin-off company.[17]

LTCM faced challenges in deploying capital as their capital base grew due to initially strong returns, and as the magnitude of anomalies in market pricing diminished over time. James Surowiecki concludes that LTCM grew such a large portion of such illiquid markets that there was no diversity in buyers in them, or no buyers at all, so the wisdom of the market did not function and it was impossible to determine a price for its assets (such as Danish bonds in September 1998).[18]

In Q4 1997, a year in which it earned 27%, LTCM returned capital to investors. It also broadened its strategies to include new approaches in markets outside of fixed income: many of these were not market neutral – they were not dependent on overall interest rates or stock prices going up (or down) – and they were not traditional convergence trades. By 1998, LTCM had accumulated extremely large positions in areas such as merger arbitrage (betting on differences between a proprietary view of the likelihood of success of mergers and other corporate transactions would be completed and the implied market pricing) and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega, which had been in demand by companies seeking to essentially insure equities against future declines.[19]

There were skeptics from the beginning

A 2014 Business Insider article, points out that there were skeptics from the very beginning:

Seth Klarman believed it was reckless to have the combination of not accounting for outliers and increasing leverage. Software designer Mitchell Kapor, who had sold a statistical program with LTCM partner Eric Rosenfeld, saw quantitative finance as a faith, rather than science. Paul Samuelson was concerned about extraordinary events affecting the market.[16]

Eugene Fama found in his research that stocks were bound to have extreme outliers. Furthermore, he believed that, because they are subject to discontinuous price changes, real-life markets are inherently more risky than models. And be became even more concerned when LTCM began adding stocks to their bond portfolio.[16]


The value of $1,000 invested in LTCM,[20] the Dow Jones Industrial Average and invested monthly in U.S. Treasuries at constant maturity.

Although periods of distress have often created tremendous opportunities for relative value strategies, this did not prove to be the case on this occasion, and the seeds of LTCM's demise were sown before the Russian default of 17 August 1998. LTCM had returned $2.7 bn to investors in Q4 of 1997, although it had also raised a total in capital of $1.066bn from UBS and $133m from CSFB. Since position sizes had not been reduced, the net effect was to raise the leverage of the fund.

Although 1997 had been a very profitable year for LTCM (27%), the lingering effects of the 1997 Asian crisis continued to shape developments in asset markets into 1998. Although this crisis had originated in Asia, its effects were not confined to that region. The rise in risk aversion had raised concerns amongst investors regarding all markets heavily dependent on international capital flows, and this shaped asset pricing in markets outside Asia too.[21]

In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Because the Salomon arbitrage group (where many of LTCM's strategies had first been incubated) had been a significant player in the kinds of strategies also pursued by LTCM, the liquidation of the Salomon portfolio (and its announcement itself) had the effect of depressing the prices of the securities owned by LTCM and bidding up the prices of the securities LTCM was short. According to Michael Lewis in the New York Times article of July 1998, returns that month were circa -10%. One LTCM partner commented that because there was a clear temporary reason to explain the widening of arbitrage spreads, at the time it gave them more conviction that these trades would eventually return to fair value (as they did, but not without widening much further first).

Such losses were accentuated through the 1998 Russian financial crisis in August and September 1998, when the Russian government defaulted on its domestic local currency bonds.[22] This came as a surprise to many investors because according to traditional economic thinking of the time, a sovereign issuer should never need to default given access to the printing press. There was a flight to quality, bidding up the prices of the most liquid and benchmark securities that LTCM was short, and depressing the price of the less liquid securities it owned. This phenomenon occurred not merely in the US Treasury market but across the full spectrum of financial assets. Although LTCM was diversified, the nature of its strategy implied an exposure to a latent factor risk of the price of liquidity across markets. As a consequence, when a much larger flight to liquidity occurred than had been anticipated when constructing its portfolio, its positions designed to profit from convergence to fair value incurred large losses as expensive but liquid securities became more expensive, and cheap but illiquid securities became cheaper. By the end of August, the fund had lost $1.85 billion in capital.

Because LTCM was not the only fund pursuing such a strategy, and because the proprietary trading desks of the banks also held some similar trades, the divergence from fair value was made worse as these other positions were also liquidated. As rumours of LTCM's difficulties spread, some market participants positioned in anticipation of a forced liquidation. Victor Haghani, a partner at LTCM, said about this time "it was as if there was someone out there with our exact portfolio,... only it was three times as large as ours, and they were liquidating all at once."

Because these losses reduced the capital base of LTCM, and its ability to maintain the magnitude of its existing portfolio, LTCM was forced to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A vivid illustration of the consequences of these forced liquidations is given by Lowenstein (2000).[23] He reports that LTCM established an arbitrage position in the dual-listed company (or "DLC") Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8%–10% premium relative to Shell. In total $2.3 billion was invested, half of which was "long" in Shell and the other half was "short" in Royal Dutch.[24]

LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge because in their belief the present value of the future cashflows of the two securities should be similar. This might have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22%, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.[25]

The company, which had historically earned annualised compounded returns of almost 40% up to this point, experienced a flight to liquidity. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion at the start of the month to just $400 million by September 25. With liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1.[26]

1998 bailout

On September 23, 1998, the chiefs of some of the largest investment firms of Wall Street—Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney—met on the 10th floor conference room of the Federal Reserve Bank of New York (pictured) to rescue LTCM.

Long-Term Capital Management did business with nearly every important person on Wall Street. Indeed, much of LTCM's capital was composed of funds from the same financial professionals with whom it traded. As LTCM teetered, Wall Street feared that Long-Term's failure could cause a chain reaction in numerous markets, causing catastrophic losses throughout the financial system.

After LTCM failed to raise more money on its own, it became clear it was running out of options. On September 23, 1998, Goldman Sachs, AIG, and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Warren Buffett gave Meriwether less than one hour to accept the deal; the time lapsed before a deal could be worked out.[27]

Seeing no options left, the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.[28] The principal negotiator for LTCM was general counsel James G. Rickards.[29] The contributions from the various institutions were as follows:[30][31]

In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established. LTCM's partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.[33]

The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt in a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):[23]

Long-Term Capital was audited by Price Waterhouse LLP. After the bailout by the other investors, the panic abated, and the positions formerly held by LTCM were eventually liquidated at a small profit to the rescuers. Although termed a bailout, the transaction effectively amounted to an orderly liquidation of the positions held by LTCM with creditor involvement and supervision by the Federal Reserve Bank. No public money was injected or directly at risk, and the companies involved in providing support to LTCM were also those that stood to lose from its failure. The creditors themselves did not lose money from being involved in the transaction.

Some industry officials said that Federal Reserve Bank of New York involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble. Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard since even though the Fed had not directly injected capital, its use of moral suasion to encourage creditor involvement emphasized its interest in supporting the financial system .[34]

LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer"[35]—a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money naked call option.


In 1998, the chairman of Union Bank of Switzerland resigned as a result of a $780 million loss incurred from the short put option on LTCM, which had become very significantly in the money due to its collapse.[1]

After the bailout, Long-Term Capital Management continued operations. In the year following the bailout, it earned 10%. By early 2000, the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back, but the collapse was devastating for many involved. Mullins, once considered a possible successor to Alan Greenspan, saw his future with the Fed dashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."[36]

After helping unwind LTCM, John Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage.[37] With the credit crisis of 2008, JWM Partners LLC was hit with a 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009.[38] Meriwether then launched a third hedge fund in 2010 called JM Advisors Management. A 2014 Business Insider article stated that his later two funds used "the same investment strategy from his time at LTCM and Salomon."[16]

See also


  1. ^ a b A financial History of the United States Volume II: 1970–2001, Jerry W. Markham, Chapter 5: "Bank Consolidation", M. E. Sharpe, Inc., 2002
  2. ^ Greenspan, Alan (2007). The Age of Turbulence: Adventures in a New World. The Penguin Press. pp. 193–195. ISBN 978-1-59420-131-8.
  3. ^ The Bank of Sweden Prize in Economic Sciences 1997. Robert C. Merton and Myron S. Scholes pictures. Myron S. Scholes with location named as "Long Term Capital Management, Greenwich, CT, USA" where the prize was received.
  4. ^ Dunbar 2000, pp. 110–pgs 111–112
  5. ^ "Chi-Fu Huang: From Theory to Practice" (PDF). Archived from the original (PDF) on 2015-09-23.
  6. ^ When Genius Failed. 2011. p. 55. While J.M. presided over the firm and Rosenfeld ran it from day to day, Haghani and the slightly senior Hilibrand had the most influence on trading.
  7. ^ Dunbar 2000, pp. 114–116
  8. ^ Loomis 1998
  9. ^ Dunbar 2000, pp. 125, 130
  10. ^ Dunbar 2000, p. 120
  11. ^ Dunbar 2000, p. 130
  12. ^ Dunbar 2000, p. 142
  13. ^ Henriques, Diana B.; Kahn, Joseph (1998-12-06). "BACK FROM THE BRINK; Lessons of a Long, Hot Summer". The New York Times. ISSN 0362-4331. Retrieved 2015-08-22.
  14. ^ Lowenstein 2000, p. 191
  15. ^ Zombie Economics: How Dead Ideas Still Walk among Us, John Quiggin (University of Queensland in Australia), Ch. 2 The Efficient Market Hypothesis, subsection "The Long-Term Capital Management Fiasco" (pages 55-58), Princeton University Press, 2010.
  16. ^ a b c d e The Epic Story Of How A 'Genius' Hedge Fund Almost Caused A Global Financial Meltdown, Business Insider, Stephanie Yang, July 10, 2014.
  17. ^ Lowenstein, Roger (2000). When Genius Failed: the Rise and Fall of Long-Term Capital Management. Random House Trade Paperbacks. pp. 95–97. ISBN 978-0-375-75825-6.
  18. ^ Surowiecki, James (2005). "Chapter 11.IV". The wisdom of crowds. New York: Anchor Books. p. 240. ISBN 9780385721707. OCLC 61254310.
  19. ^ Lowenstein 2000, pp. 124–25
  20. ^ Lowenstein 2000, p. xv
  21. ^ O'Rourke, Breffni (1997-09-09). "Eastern Europe: Could Asia's Financial Crisis Strike Europe?". RadioFreeEurope/RadioLiberty. Retrieved 2015-08-22.
  22. ^ Bookstaber, Richard (2007). A Demon Of Our Own Design. USA: John Wiley & Sons. pp. 97–124. ISBN 978-0-470-39375-8.
  23. ^ a b Lowenstein 2000
  24. ^ Lowenstein 2000, p. 99
  25. ^ Lowenstein 2000, p. 234
  26. ^ Lowenstein 2000, p. 211
  27. ^ Lowenstein 2000, pp. 203–04
  28. ^ Partnoy, Frank (2003). Infectious Greed: How Deceit and Risk Corrupted the Financial Markets. Macmillan. p. 261. ISBN 978-0-8050-7510-6.
  29. ^ Kathryn M. Welling, "Threat Finance: Capital Markets Risk Complex and Supercritical, Says Jim Rickards" welling@weeden (February 25, 2010). Retrieved May 13, 2011
  30. ^ Wall Street Journal, 25 September 1998
  31. ^ Bloomberg.com: Exclusive
  32. ^ a b http://eml.berkeley.edu/~webfac/craine/e137_f03/137lessons.pdf
  33. ^ Lowenstein 2000, pp. 207–08
  34. ^ GAO/GGD-00-67R Questions Concerning LTCM and Our Responses General Accounting Office, February 23, 2000
  35. ^ Lowenstein 2000, p. 102
  36. ^ Lowenstein 2000, p. 235
  37. ^ Lowenstein 2000, p. 236
  38. ^ "John Meriwether to shut hedge fund - Bloomberg". Reuters. July 8, 2009. Retrieved 11 January 2018.


  • Coy, Peter; Wooley, Suzanne (21 September 1998). "Failed Wizards of Wall Street". Business Week. Retrieved 2006-09-04.
  • Crouhy, Michel; Galai, Dan; Mark, Robert (2006). The Essentials of Risk Management. New York: McGraw-Hill Professional. ISBN 978-0-07-142966-5.
  • Dunbar, Nicholas (2000). Inventing Money: The story of Long-Term Capital Management and the legends behind it. New York: Wiley. ISBN 978-0-471-89999-0.
  • Jacque, Laurent L. (2010). Global Derivative Debacles: From Theory to Malpractice. Singapore: World Scientific. ISBN 978-981-283-770-7.. Chapter 15: Long-Term Capital Management, pp. 245–273
  • Loomis, Carol J. (1998). "A House Built on Sand; John Meriwether's once-mighty Long-Term Capital has all but crumbled. So why did Warren Buffett offer to buy it?". Fortune. 138 (8).
  • Lowenstein, Roger (2000). When Genius Failed: The Rise and Fall of Long-Term Capital Management. Random House. ISBN 978-0-375-50317-7.
  • Weiner, Eric J. (2007). What Goes Up, The Uncensored History of Modern Wall Street. New York: Back Bay Books. ISBN 978-0-316-06637-2.

Further reading

A Demon of Our Own Design

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (2007) is a book by veteran Wall Street risk manager Richard Bookstaber. The book is noted for its foreshadowing of the financial crisis of 2007–08.

Bookstaber had a "a front-row seat" for such crises as the stock market crash of 1987 and the demise of Long-Term Capital Management, and his book is built around themes drawn from those experiences.

The theme of the book is that the world financial system is vulnerable to singularities—disasters arising out of apparently trivial details, as implied by chaos theory and its Butterfly effect. He discusses the critical and often underappreciated role of liquidity in the markets and presents a theory of 'normal accidents' arising from the combination of tight coupling and complexity. Bookstaber reviews accidents such as Three Mile Island, ValueJet, and Columbia as examples of 'normal accidents' that have corollaries in the financial markets.

The efficient market hypothesis comes under attack in this book using biological and evolutionary analogies. He suggests that overspecialization to an environment leads one vulnerable to change. Therefore, the best adaptive approach is often to have a 'coarse' approach that may ignore fine grained stimuli.

Risk management, however sophisticated it is or can become, will not end this vulnerability. To the contrary, "the more intricate risk-management structures may actually make the system worse."

The book, in fact, "provides a warning about injudiciously applying advanced quantitative techniques to investment instruments".The dust jacket carries a detail of "The Fall of Icarus," by Jacob Peter Gowy.


In economics and finance, arbitrage (, UK also ) is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a (imagined, hypothetical, thought experiment) transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the opportunity to instantaneously buy something for a low price and sell it for a higher price.

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage.

People who engage in arbitrage are called arbitrageurs —such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

Arbitrage has the effect of causing prices of the same or very similar assets in different markets to converge.

Chi-fu Huang

Chi-fu Huang (黄奇辅; born 1955) is a private investor, a retired hedge fund manager, and a former finance academic. He has made major contributions to the theory of financial economics, writing on dynamic general equilibrium theory, intertemporal utility theory, and the theory of individual consumption and portfolio decisions. He is a Managing Member of CMASH, LLC, a member of the Management Committee of Starling Ventures, LLC, a Board Member of DeepMacro, LLC and an owner of ConvexityWines.com. He serves on Corporate Development Committee and Advisory Board of Dean of School of Sciences, Massachusetts Institute of Technology.

David W. Mullins Jr.

David Wiley Mullins Jr. (April 28, 1946 - February 26, 2018) was an American economist and former vice-chairman of the Federal Reserve. He also served as an assistant Secretary of the Treasury for domestic finance in the administration of United States President George H. W. Bush. Mullins left the Federal Reserve in 1994 to join the hedge fund Long Term Capital Management and remained in private finance following its collapse in 1998.

Eric Rosenfeld

Eric R. Rosenfeld was a trader and principal at Long-Term Capital Management, a major hedge fund that failed during the Russian financial crisis.

Fixed-income relative-value investing

Fixed-Income Relative-Value Investing (FI-RV) is a hedge fund investment strategy made popular by the failed hedge fund Long-Term Capital Management.

FI-RV Investors most commonly exploit interest-rate anomalies in the large, liquid markets of North America, Europe and the Pacific Rim. The financial instruments traded include government bonds, interest rate swaps and futures contracts.


A flight-to-liquidity is a financial market phenomenon occurring when investors sell what they perceive to be less liquid or higher risk investments, and purchase more liquid investments instead, such as US Treasuries. Usually, flight-to-liquidity quickly results in panic leading to a crisis.

For example, after the Russian government defaulted on its government bonds (GKOs) in 1998 many investors sold European and Japanese government bonds and purchased on-the-run US Treasuries instead.

(The most recently issued treasuries, known as “on-the-run”, have larger trading volumes, that is more liquidity, than treasury issues that have been superseded, known as “off-the run”.)

This widened the spread between off-the-run and on-the-run US Treasuries, which ultimately led to the 1998 collapse of the Long-Term Capital Management hedge fund.

Greg Hawkins

Gregory Dale Hawkins was a trader and principal in the hedge fund Long-Term Capital Management that after four spectacularly successful years lost most of its clients' money in 1998 when the Russian government defaulted on its debt payments on August 17, 1998, triggering a devaluation of the Russian ruble. Long-Term Capital had $4.6 billion in portfolio losses in a few months and only avoided outright bankruptcy because the U.S. central bank prompted a consortium of large global investment banks and counter-parties of LTCM to provide an equity bailout. LTCM shutdown in early 2000.

Hawkins lives in New Rochelle in Westchester County, New York.

JWM Partners

JWM Partners LLC was a hedge fund started by John Meriwether after the collapse of Long Term Capital Management (LTCM) in 1998. LTCM was one of the most spectacular failures of Wall Street, leading to a bailout of around $4 billion that was provided by a consortium of Wall Street banks. Meriwether started the company with initial capital of $250 million with loyal quants and traders like Victor Haghani, Larry Hilibrand, Dick Leahy, Arjun Krishnamachar and Eric Rosenfeld. As of April 2008, the company had around $1.6 billion in management. Eric Rosenfeld left to start his own fund.

John Meriwether

John William Meriwether (born August 10, 1947) is an American hedge fund executive, seen as a pioneer of fixed income arbitrage.

Kurtosis risk

In statistics and decision theory, kurtosis risk is the risk that results when a statistical model assumes the normal distribution, but is applied to observations that have a tendency to occasionally be much farther (in terms of number of standard deviations) from the average than is expected for a normal distribution.

Kurtosis risk applies to any kurtosis-related quantitative model that assumes the normal distribution for certain of its independent variables when the latter may in fact have kurtosis much greater than does the normal distribution. Kurtosis risk is commonly referred to as "fat tail" risk. The "fat tail" metaphor explicitly describes the situation of having more observations at either extreme than the tails of the normal distribution would suggest; therefore, the tails are "fatter".

Ignoring kurtosis risk will cause any model to understate the risk of variables with high kurtosis. For instance, Long-Term Capital Management, a hedge fund cofounded by Myron Scholes, ignored kurtosis risk to its detriment. After four successful years, this hedge fund had to be bailed out by major investment banks in the late 1990s because it understated the kurtosis of many financial securities underlying the fund's own trading positions.Benoit Mandelbrot, a French mathematician, extensively researched this issue. He felt that the extensive reliance on the normal distribution for much of the body of modern finance and investment theory is a serious flaw of any related models including the Black–Scholes option model developed by Myron Scholes and Fischer Black, and the capital asset pricing model developed by William F. Sharpe. Mandelbrot explained his views and alternative finance theory in his book: The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward published on September 18, 1997.

Larry Hilibrand

Larry Hilibrand (born circa 1959) is a mathematically-inclined arbitrage trader with two degrees from MIT. He was the top-paid arbitrage trader at Salomon Brothers in 1992 and at the time the youngest managing director in Salomon Brothers history and hence was nicknamed the "teenage" managing director

At the behest of John Meriwether, Hilibrand subsequently left Salomon to become one of the founding partners of the hedge fund Long-Term Capital Management (LTCM) where—during the peak of LTCM's success—he was worth half a billion dollars. LTCM failed abruptly in August/September 1998. Hilibrand had invested so much of his personal wealth in LTCM that when LTCM failed, he found himself broke.Since the LTCM failure in 1998, Hilibrand has flown under the radar. He joined a group (again led by Meriwether) that started a new fund, JWM Partners LLC. JWM Partners closed in 2009, having lost 42% of its capital.

Hilibrand currently lives in Greenwich where he is devoted to his wife and children. Larry is an avid runner placing in many state and regional events.

Llama Company

The Llama Company was an investment bank founded by Alice Walton as a subsidiary of Walton Enterprises. It was headquartered in Fayetteville, Arkansas, and was founded in 1988, and was engaged in corporate finance, public and structured finance, real estate finance and sales and trading. Walton was President, Chairperson, and CEO of the company. The Walton family also operates a commercial bank, Arvest Bank. Alice's ownership stake in Llama likely prevented her from having equity in Arvest.Although initially somewhat successful, the bank was closed in 1998 due to Walton's legal problems and economic uncertainty that also caused the failure of Long-Term Capital Management, a hedge fund. Llama went defunct approximately one month after Walton resigned from her role as its chief executive. Upon closure, the bank employed roughly ninety people.

Long-Term Capital Holdings v. United States

Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004), was a court case argued before the United States District Court for the District of Connecticut that concerned a tax shelter used by Long-Term Capital Management, a failed hedge fund.The tax shelter had been designed by Babcock & Brown for Long-Term Capital to shelter it's short-term trading gains from 1997.

The case was an appeal of an Internal Revenue Service denial of the plaintiffs' claim of $106,058,228 in capital losses during the 1997 tax year and associated penalties. After a bench trial, Judge Janet Bond Arterton ruled, on August 27, 2004, that the transactions employed by Long-Term Capital Holdings did not have economic substance and so were disregarded for tax purposes.

Myron Scholes

Myron Samuel Scholes ( SHOHLZ; born July 1, 1941) is a Canadian-American financial economist. Scholes is the Frank E. Buck Professor of Finance, Emeritus, at the Stanford Graduate School of Business, Nobel Laureate in Economic Sciences, and co-originator of the Black–Scholes options pricing model. Scholes is currently the chairman of the Board of Economic Advisers of Stamos Capital Partners. Previously he served as the chairman of Platinum Grove Asset Management and on the Dimensional Fund Advisors board of directors, American Century Mutual Fund board of directors and the Cutwater Advisory Board. He was a principal and limited partner at Long-Term Capital Management, L.P. and a managing director at Salomon Brothers. Other positions Scholes held include the Edward Eagle Brown Professor of Finance at the University of Chicago, senior research fellow at the Hoover Institution, director of the Center for Research in Security Prices, and professor of finance at MIT’s Sloan School of Management. Scholes earned his PhD at the University of Chicago.

In 1997 he was awarded the Nobel Memorial Prize in Economic Sciences for a method to determine the value of derivatives. The model provides a conceptual framework for valuing options, such as calls or puts, and is referred to as the Black–Scholes model.

Robert C. Merton

Robert Cox Merton (born July 31, 1944) is an American economist, Nobel Memorial Prize in Economic Sciences laureate, and professor at the MIT Sloan School of Management, known for his pioneering contributions to continuous-time finance, especially the first continuous-time option pricing model, the Black–Scholes formula. In 1993 Merton co-founded hedge fund Long-Term Capital Management. In 1997 he received the Nobel Prize for his contributions in Economics.

Salomon Brothers

Salomon Brothers was an American investment bank founded in 1910 by Arthur, Herbert and Percy Salomon and a clerk named Ben Levy, remaining a partnership until the early 1980s. It was acquired by the commodity trading firm Phibro Corporation and became Salomon Inc. Eventually, Salomon (NYSE:SB) was acquired by Travelers Group in 1998; and, following the latter's merger with Citicorp that same year, Salomon became part of Citigroup. Although the Salomon name carried on as Salomon Smith Barney, which were the investment banking operations of Citigroup, the name was abandoned in October 2003 after a series of financial scandals that tarnished the bank's reputation.

Victor Haghani

Victor Haghani (born c. 1962) is an Iranian-American financier, one of the founding partners of Long Term Capital Management (LTCM), a hedge fund which collapsed in 1998 and was eventually bailed out by a consortium of leading banks. The son of an Iranian international trader of a Sephardic Jewish family, Haghani graduated from the London School of Economics (LSE). He was a founding partner of LTCM and after the liquidation of LTCM became a founding partner of JWM Partners which managed a successor fund to LTCM.

When Genius Failed

When Genius Failed: The Rise and Fall of Long-Term Capital Management is a book by Roger Lowenstein published by Random House on October 9, 2000. The book puts forth an unauthorized account of the creation, early success, abrupt collapse, and rushed bailout of Long-Term Capital Management (LTCM). LTCM was a tightly-held American hedge fund founded in 1993 which commanded more than $100 billion in assets at its height, then collapsed abruptly in August/September 1998. Prompted by deep concerns about LTCM's thousands of derivative contracts, in order to avoid a panic by banks and investors worldwide, the Federal Reserve Bank of New York stepped in to organize a bailout with the various major banks at risk.

The book's account is largely based on interviews conducted with former employees of LTCM, the six primary banks involved in the rescue, and the Federal Reserve, as well as informal interactions by phone and e-mail with Eric Rosenfeld, one of LTCM's founding partners. As of 2014, there have been four editions in English, five editions in Japanese, one edition in Russian and one edition in Chinese.The book received numerous accolades, including being chosen by BusinessWeek among the best business books of 2000.


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