Examination of VaR after long term capital management

Yalincak, Hakan and Li, Yu and Tong, Mike (2005): Examination of VaR after long term capital management.

Abstract

The 1998 failure of Long-Term Capital Management (‘LTCM’), a very large and prominent Greenwich, Connecticut based hedge fund, is said to have nearly brought down the world financial system. Over the years, few financial debacles such as LTCM, have been so often written about or discussed without a firm conclusion on what went wrong. What brought the “genius” managers of LTCM to their knees? Was it hubris, or was it something more? Various commentators have jumped on LTCM’s significant leverage ratio or engaged in second-guessing of management’s decision in 1997 to return $2.7 billion of investor capital to increase leverage, and thereby, returns. Others have faulted the lack of transparency at LTCM or faulted regulators for a lack of oversight, criticized regulators for arranging the bailout, while others still have pinpointed the debacle on the failure of LTCM’s risk management prowess. This paper avoids the blame and identifies the multiple factors, both management risk management blunders, as well as inherent flaws in the risk metric used by LTCM – Value at Risk (VaR) – a commonly used risk metric in the financial industry today.

• Item Type: MPRA Paper
• Language: English
• Keywords: Hakan Yalincak, Mike Tong, Yu Li, New York University, Value At Risk, Long Term Capital Management, Volatility, Swap Spreads, Convergence Arbitrage
• Subjects: C - Mathematical and Quantitative Methods > C0 - General > C02 - Mathematical Methods; A - General Economics and Teaching > A1 - General Economics > A10 - General; A - General Economics and Teaching > A1 - General Economics > A11 - Role of Economics ; Role of Economists ; Market for Economists

References

-Basle Committee on Banking Supervision (1995), An Internal Model-Based Approach to Market Risk Capital Requirements, Basle, Switzerland: BIS.

-Basle Committee on Banking Supervision (1996), Supervisory Framework for the Use of ‘Backtesting’ in Conjunction with the Internal Models Approach to Market Risk Capital Requirements, Basle, Switzerland

-Bollerslev, T., Chou, R., and Kroner, K., Arch Modelling in Finance: A review of the Theory and Empirical Evidence, (1992) Journal of Econometrics 52.

-Brown, S., Goetzmann, W., Ibbotson, R., Offshore Hedge Funds: Survival and Performance: 1989-1995, Journal of Business (January) 72: 91-117.

-Butler, C., Mastering Value At Risk: A Step-by-Step Guide to Understanding and Applying VaR (Pearson Education Limited: Harlow, 1998).

-Dunbar, N., Inventing Money: The story of Long-Term Capital Management and the legends behind it. (New York, 2000).

-Dunbar, N., “Meriwether’s Meltdown”, Risk (October, 1998) 32-36.

-Edwards, Franklin R., “Hedge Funds and the Collapse of Long-Term Capital Management,” Journal of Economic Perspectives, (1999) 13, No. 2, 189-210.

-Fabozzi, F.J., ed., The Handbook of Fixed Income Securities (6th edn., McGrawhill: New York, 2005); see also -Hull, J.C., Options Futures and Other Derivatives (5th edn., Prentice Hall, 2002).

-Jorion, P., “Risk Management Lessons from Long-Term Capital Management” (1999).

-Kolman, J., LTCM Speaks, Derivatives Strategy (April 1999), 12-17.

-Lamont, O.A., Thaler, R.H., Anomalies: The Law of One Price in Financial Markets (2003) 17(4) Journal of Economic Progress 191-2002.

-Leeson, N., Rogue Trader (Warner Books: London, 1997).

-Lewis, M., “How the Eggheads Cracked,” New York Times Magazine, January (1999).

-Lewis, M., Liar’s Poker (Penguin Books: New York, 2000).

-Lowenstein, R., When Genius Failed: The Rise and Fall of Long Term Capital Management (New York: Random House, 2000).

-Malkiel, B., McCue, K., A Random Walk Down Wall Street, (W.W. Norton & Company: New York, 1996).

-Mandelbrot, B.B., The Variation of Certain Speculative Prices (1963) 36(4) Journal of Business 394-419.

-Taleb, N., The Jorion-Taleb Debate, Derivatives Strategy (April 1997).

-Taleb, N.N., Fooled by Randomness (Random House: New York, 2004).

-Trillion Dollar Bet, Dir. Malcolm Clark, Videocassette, BBC/WGBH Boston, 1999.

-President’s Working Group on Financial Markets, Hedge Funds, Leverage and the Lessons of Long Term Capital Management, Washington D.C. (1999).

-House Committee on Banking and Financial Services. 1999. Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management: Report of the President’s Working Group on Capital Markets (April).

-House Committee on Banking and Financial Services. 1999. Hearings on the President’s Working Group Study on Hedge Funds, 106th Congress, 1st session, Serial no. 106–19.

-House Committee on Banking and Financial Services. 1998. Testimony of Alan Greenspan at the Hearing on Hedge Fund Operations: before the House Committee on Banking and Financial Services, 105th Congress, 2nd session, (October 1), Serial 105–80.

- Personal Communication by Jack DiMaio in August 2004 at a dinner in Greenwich, Connecticut. Mr. DiMaio is a partner at DiMaio & Nassert, LLC and former trader at Credit Suisse First Boston (NYC).