The difference between the market and Brownian motion lies within the greed and fear of investors. LTCM doomed with 30x leverage and skyrocking divergence of bond swap spreads in Sep. 1998, a month after Russia defaulted...
John Meriwether, once the head of bond arbitrage group at Salomon Brothers, recruited young associate professors from MIT and Harvard. His gang, the arbitrageurs including Larry Hilibrand and Victor Haghani, were the cornerstones of the future LTCM. Resigned from Salomon after an insider trading scandal, Meriwether started LTCM with his loyal pack. The fund sailed out with $1.25bn and two future Nobel laureates Robert Merton and Myron Scholes.
The professors developed complicated model using Black-Scholes dynamic hedging strategy, which measures historical volatility of spreads on govt bonds. When the spreads between a less liquid bond and a highly liquid bond widen because of investors irrational action, the arbitrageurs would buy the less liquid bond at discount. They characterized themselves as "liquidity provider", or "picking up pennies in front of bulldozer".
eg:
"Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a 30 year treasury bond and a 29 and three quarter year old treasury bond should be minimal—both will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bonds because of a difference in liquidity.[12] By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting the more expensive, but more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond was issued"
Leveraging European unification, they successfully bet on the convergence of spreads between different European bonds, making tons from Italian bonds. However, as more competitors founded quant desk for arbitrage, LTCM entered riskier Equity Vol trading and Merger Arbitrage.
Equity Volatility tapped on the divergence between option and its underlying equity. Eg. A stock has historical annual volatility of 15%, but its option is priced at a premium, representing 20% of volatility of the stock. The arbitrageurs would short the option. Equity Vol is essentially an insurance against BOTH sharp downturn and rise. Wall Street gave LTCM a nickname "Central Bank of Volatility".
However, even though most LTCM's trades were market neutral as they were betting on the spreads instead of direction, the arbitrageurs leveraged to a level impossible to liquidate upon catastrophe. The reason is that LTCM could -> borrow to buy off-the-run bond -> loan it to a bank and get cash - repo financing -> pay off the initial borrowed money. The limit of the whole process - Haircut, a discount of collateral, however, was waived by most parts by banks on the street.
On August 17 1998, Russia defaulted on its bonds. Initially the banks claimed that the crisis was a contained one. However, scared investors fled from their emerging markets bonds even the AAA rating corporate bonds to the safest US treasury. The spreads between US treasury bill and AAA corporate bonds widened unprecedentedly. LTCM lost both sides of the trades in every single markets. By the end of Sep. 1998, LTCM has lost over 45% of its capital.
Fear and Greed - When Genius Failed
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