LTCM

1
LTCMs Analysis of Risk Management

• February 28, 2002
• Frank Burke
• Larry Kissko
• Gurkan Salk
• Heather King

2
Agenda

• LTCM Background
• Swap Spread Trading Strategy
• Project Analysis
• Comparison/measurement of LTCMs Risk Assessment
• Discussion on return and spread distribution,
  calculated implied std deviation
• Estimate of LTCMs Value-At-Risk
• Proxy Tests
• Take-aways

3
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
• LTCMs swap position represented 2.4 of global
  swap market in December 1997
• Leverage ratios varied from 281 to a high of
  551 in late 1998

4
LTCM Trading Strategy

• We focused on of one of LTCMs 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

5
Swap Spread Frequency the bet
6
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

7
Swap Returns Distribution (thru 7/98)
8
Analytic Results
Risk analysis LTCM Satchmo
Return distribution Normal Curve Non-normal w/Kurtosis fat tails
99.7 confidence interval - 6.07, 6.10 from the mean return 0.01 - 10.32, 10.39 from the mean return 0.01
Implied Daily Std. deviation 2.03 3.46
Value at Risk (VAR) - estimated 60M 95.2M
Probability of Aug 21 event 10-13 Or .00000000001 .16 4 observations over 10 year period
9
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

10
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 (Students
  T curve)

11
Appendix - charts
August 21, 2002
12
Appendix - charts
13
Appendix - charts
14
Appendix - charts
15
Appendix - charts
16
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