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faculty.fuqua.duke.edu

  1. 1. LTCM’s Analysis of Risk Management February 28, 2002 Frank Burke Larry Kissko Gurkan Salk Heather King
  2. 2. Agenda <ul><li>LTCM Background </li></ul><ul><li>Swap Spread Trading Strategy </li></ul><ul><li>Project Analysis </li></ul><ul><ul><li>Comparison/measurement of LTCM’s Risk Assessment </li></ul></ul><ul><ul><li>Discussion on return and spread distribution, calculated implied std deviation </li></ul></ul><ul><ul><li>Estimate of LTCM’s Value-At-Risk </li></ul></ul><ul><ul><li>Proxy Tests </li></ul></ul><ul><li>Take-aways </li></ul>
  3. 3. LTCM Background <ul><li>August 21, 1998, fund lost $550m mostly from swaps spreads and equity volatility bets. </li></ul><ul><ul><li>LTCM believed this event would occur 1 in every 800 trillion years (or an 8.3 std dev move). </li></ul></ul><ul><ul><li>Swap spreads shot up from 60 bps to 80 bps intraday vs. an average daily move of 2 bps </li></ul></ul><ul><li>LTCM’s swap position represented 2.4% of global swap market in December 1997 </li></ul><ul><li>Leverage ratios varied from 28:1 to a high of 55:1 in late 1998 </li></ul>
  4. 4. LTCM Trading Strategy <ul><li>We focused on of one of LTCM’s biggest trades: </li></ul><ul><li>Swap Spread Relative Value Trade </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>Speculative strategy that spread would converge to its historical mean </li></ul></ul><ul><ul><li>Long swap/short the treasuries (in 1998) </li></ul></ul><ul><li>Crisis: Aug 21, spreads spiked 21 bps intra-day </li></ul>
  5. 5. Swap Spread Frequency: “the bet”
  6. 6. Project Analysis <ul><li>Parametric VAR – assumes normal distribution </li></ul><ul><li>Historical VAR – based on actual data distribution </li></ul><ul><li>Proxy search – difficult to find a strong correlation </li></ul><ul><ul><li>BAA- 10 year treasury </li></ul></ul><ul><ul><li>AAA- 10 year treasury </li></ul></ul><ul><ul><li>MBS - 10 year treasury </li></ul></ul><ul><li>Forecasted daily variance </li></ul><ul><li>Value At Risk – defined as the expected maximum loss over a target horizon within a given confidence interval </li></ul>
  7. 7. Swap Returns Distribution (thru 7/98)
  8. 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. 9. Value at Risk (VAR) <ul><li>Principal measure of risk at LTCM </li></ul><ul><li>LTCM parametric VAR measure </li></ul><ul><ul><li>Capital (assume $1b) x daily std dev of returns (.02) x std dev of required confidence interval (3 = 99.85% 1-tail) </li></ul></ul><ul><ul><li>$1.0b x 2% x 3 = $60,000,000 </li></ul></ul><ul><li>Our historical VAR measure </li></ul><ul><ul><li>$ 1.0b x 9.5238% = $95,238,000 </li></ul></ul>
  10. 10. Take-Away Thoughts <ul><li>VAR not necessarily suspect – correct inputs are critical </li></ul><ul><li>Cannot blindly apply normal distribution </li></ul><ul><li>Dig into your data </li></ul><ul><li>If data is not complete consider: </li></ul><ul><ul><li>Developing a risk proxy </li></ul></ul><ul><ul><li>Assuming fatter tails in distribution (Student’s T curve) </li></ul></ul>
  11. 11. Appendix - charts August 21, 2002
  12. 12. Appendix - charts
  13. 13. Appendix - charts
  14. 14. Appendix - charts
  15. 15. Appendix - charts
  16. 16. References <ul><li>Jorion, P., 2000 Risk Management Lessons from LTCM </li></ul><ul><li>Kolman, Joe, 1999, “LTCM Speaks”, Derivatives Strategy (April) p.12-17 </li></ul><ul><li>Lewis, Michael, 1999, “How the Egg-Heads Cracked” New York Times Magazine, January 24, p 24-77 </li></ul><ul><li>Anonymous, 1998, “Too Clever By Half”, The Economist Magazine, November 14 </li></ul><ul><li>Whaley, Robert, 2001, “Derivatives” Class Presentation </li></ul><ul><li>Scholes, Myron, 2000, “Crisis and Risk Management- The Near Crash of 1998”, AEA Papers and Proceedings Vol 90 No. 2, May. </li></ul><ul><li>Bloomberg – Swap spread data </li></ul>

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