Subject: The failure of Long Term Capital Management. See also gjm’s recommendation of Lowenstein, but Dunbar supplies a briefer and more financially sophisticated treatment.
Lessons: The danger of leverage, which is one potentially very expensive form of overconfidence. The world contains more risks than anyone, no matter how clever, can think of to hedge against. LTCM, contrary to popular belief, did in fact hedge against Russia defaulting on its own bonds, through currency forward contracts. What they failed to hedge against was Russia then suspending payment on the forward contracts, and hiding its hard currency.
I disagree strongly that “the danger of leverage” is the key message of LTCM. The key message for rationalists has to do with the subtle nature of correlation; the key message for risk managers has to do with the importance of liquidity.
“The danger of leverage” also isn’t much of a message. That’s like saying the message of the Iraq War is “the danger of foreign policy.”
Does “popular belief” hold that LTCM wasn’t hedged? Anyone who believes that is very far from learning anything from the LTCM story.
Overconfidence leads one to seek leverage. Leverage in turn magnifies the consequences of errors. Leverage on LTCM’s scale, which dwarfed that of its predecessors, turns errors into catastrophes.
Another, probably more important lesson concerns the degree to which one should rely on historical data. If something never has happened, or at least not recently, one cannot safely bet the house that it never will happen.
I probably shouldn’t have speculated on what “popular belief” does or does not hold, but it has often been written, falsely, that LTCM was unhedged against Russia defaulting on its own bonds.
Inventing Money, by Nicholas Dunbar
Subject: The failure of Long Term Capital Management. See also gjm’s recommendation of Lowenstein, but Dunbar supplies a briefer and more financially sophisticated treatment.
Lessons: The danger of leverage, which is one potentially very expensive form of overconfidence. The world contains more risks than anyone, no matter how clever, can think of to hedge against. LTCM, contrary to popular belief, did in fact hedge against Russia defaulting on its own bonds, through currency forward contracts. What they failed to hedge against was Russia then suspending payment on the forward contracts, and hiding its hard currency.
I disagree strongly that “the danger of leverage” is the key message of LTCM. The key message for rationalists has to do with the subtle nature of correlation; the key message for risk managers has to do with the importance of liquidity.
“The danger of leverage” also isn’t much of a message. That’s like saying the message of the Iraq War is “the danger of foreign policy.”
Does “popular belief” hold that LTCM wasn’t hedged? Anyone who believes that is very far from learning anything from the LTCM story.
Overconfidence leads one to seek leverage. Leverage in turn magnifies the consequences of errors. Leverage on LTCM’s scale, which dwarfed that of its predecessors, turns errors into catastrophes.
Another, probably more important lesson concerns the degree to which one should rely on historical data. If something never has happened, or at least not recently, one cannot safely bet the house that it never will happen.
I probably shouldn’t have speculated on what “popular belief” does or does not hold, but it has often been written, falsely, that LTCM was unhedged against Russia defaulting on its own bonds.
The danger I see here is being exposed on a deal with a party who has a gun to your head.