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  • 1. LTCM’s 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 LTCM’s Risk Assessment
      • Discussion on return and spread distribution, calculated implied std deviation
      • Estimate of LTCM’s 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
    • LTCM’s swap position represented 2.4% of global swap market in December 1997
    • Leverage ratios varied from 28:1 to a high of 55:1 in late 1998
  • 4. LTCM Trading Strategy
    • We focused on of one of LTCM’s 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 $95.2M $60M Value at Risk (VAR) - estimated .16% = 4 observations over 10 year period 10 -13 Or .00000000001% Probability of Aug 21 event 3.46% 2.03% Implied Daily Std. deviation [ - 10.32%, +10.39% ] from the mean return 0.01% [ - 6.07%, + 6.10% ] from the mean return 0.01% 99.7% confidence interval Non-normal: w/Kurtosis & fat tails Normal Curve Return distribution Satchmo LTCM Risk analysis
  • 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 (Student’s 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