Knowing that there is a mispricing doesn’t tell you what the correct price actually is, which is what you need to know in order to make better money than random-walk models.
Knowing that there is a mispricing doesn’t tell you what the correct price actually is
In this particular case the problem mentioned is too thin tails of the underlying distribution. If you believe the problem is real, you know the sign of the mispricing and that’s all you need.
For this particular example, this basically means that you can predict that LTCM will fail spectacularly when rare negative events happen. But could you reliably make money knowing that LTCM will fail eventually? If you buy their options that pay off when terrible things happen, you’re trusting that they’ll be able to pay the debts you’re betting they can’t pay. If you short them, you’re betting that the failure happens before you run out of money.
But could you reliably make money knowing that LTCM will fail eventually?
Just LTCM, no. But (if we ignore the transaction costs which make this idea not quite practicable) there are enough far-out-of-the-money options being traded for me to construct a well-diversified portfolio that would allow me to reliably make money—of course, only if these options were Black-Scholes priced on the basis of the same implied volatility as the near-the-money options and in reality they are not.
IIRC, LCTM ended up in disaster not only because of a Russian default/devaluation. They had contracts with Russian banks that would have protected them, except that the Russian government also passed a law making it illegal for Russian banks to pay out on those contracts. It’s hard to hedge against all the damage a government can do if it wants.
As a historical note, the LTCM crisis was caused by Russias default, but LTCM did not bet on Russia or rely on Russian banks. LTCMs big bet was on a narrowing of the price difference between 30 year treasurys and 29 year treasurys. When Russia defaulted people moved out of risky assets into safe assets and lots of people bought 30 years. That temporary huge burst in demand led to a rise in the price of 30s. Given the high leverage of LTCM that was enouph to make them go bust.
This is correct. LTCM’s big trade was a convergence trade which was set up to guarantee profit at maturity. Unfortunately for them LTCM miscalculated volatility and blew up because, basically, it could not meet a margin call.
Knowing that there is a mispricing doesn’t tell you what the correct price actually is, which is what you need to know in order to make better money than random-walk models.
In this particular case the problem mentioned is too thin tails of the underlying distribution. If you believe the problem is real, you know the sign of the mispricing and that’s all you need.
For this particular example, this basically means that you can predict that LTCM will fail spectacularly when rare negative events happen. But could you reliably make money knowing that LTCM will fail eventually? If you buy their options that pay off when terrible things happen, you’re trusting that they’ll be able to pay the debts you’re betting they can’t pay. If you short them, you’re betting that the failure happens before you run out of money.
Just LTCM, no. But (if we ignore the transaction costs which make this idea not quite practicable) there are enough far-out-of-the-money options being traded for me to construct a well-diversified portfolio that would allow me to reliably make money—of course, only if these options were Black-Scholes priced on the basis of the same implied volatility as the near-the-money options and in reality they are not.
This assumes the different black swans are uncorrelated.
Yes, to a degree. However in this particular case I can get exposure to both negative shocks AND positive shocks—and those certainly are uncorrelated.
LTCM should not be your counter-party! Also, using a clearinghouse eliminates much of the risk.
IIRC, LCTM ended up in disaster not only because of a Russian default/devaluation. They had contracts with Russian banks that would have protected them, except that the Russian government also passed a law making it illegal for Russian banks to pay out on those contracts. It’s hard to hedge against all the damage a government can do if it wants.
As a historical note, the LTCM crisis was caused by Russias default, but LTCM did not bet on Russia or rely on Russian banks. LTCMs big bet was on a narrowing of the price difference between 30 year treasurys and 29 year treasurys. When Russia defaulted people moved out of risky assets into safe assets and lots of people bought 30 years. That temporary huge burst in demand led to a rise in the price of 30s. Given the high leverage of LTCM that was enouph to make them go bust.
Thanks for the correction—I had once seen part of a documentary on LCTM and that was what I remembered from it.
This is correct. LTCM’s big trade was a convergence trade which was set up to guarantee profit at maturity. Unfortunately for them LTCM miscalculated volatility and blew up because, basically, it could not meet a margin call.