Inventing Money

Inventing Money The Story of Long-Term Capital Management And the Legends Behind It

by Nicholas Dunbar John Wiley & Sons © 2000 245 pages

Focus Leadership Strategy

Take-Aways • New financial instruments created new investment opportunities in the late 1970s and early 1980s.

Sales & Marketing Corporate Finance Human Resources Technology Production & Logistics Small Business Economics & Politics Industries & Regions Career Development Personal Finance

• To exploit these opportunities, former Salomon Brothers Vice Chair John Meriwether founded Long-Term Capital Management (LTCM). • Meriwether brought in Nobel laureates Myron Scholes and Robert Merton, winners for their theory of option pricing. • Before the 1970s, professional investors used traditional research methods to evaluate stocks. • The Black-Scholes pricing formula shows whether an option was fairly priced. • Such theories formed the basis of the sophisticated computer modeling that drove LTCM.

Self Improvement Ideas & Trends

• LTCM grew because investment bankers blindly supported it, ignoring potential risks. • Black, Scholes and Merton’s theories were based on incorrect assumptions. • Markets are not frictionless, continuous or limitless in their liquidity. • LTCM failed in 1998 with a $2.5 billion loss following the collapse in Southeast Asia.

Rating Overall

7

(10 is best)

Applicability

5

Innovation

Style

8

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Review What You Will Learn In this Abstract you will learn: 1) How the creation of new financial instruments, theories and technology spawned new investment opportunities in the 1970s, 80s and 90s; 2) How a group of bond traders and mathematicians raised billions of dollars for the LongTerm Capital Management hedge fund; 3) How this hedge fund used leverage and sophisticated computer modeling to generate unprecedented investment returns, and 3) How these models failed in a collapse that threatened world financial markets. Recommendation Author Nicholas Dunbar captures both the personalities and complex financial theories that built Long-Term Capital Management, the hedge fund that threatened to bring down world markets in its spectacular 1998 collapse. His explanation of arcane markets will be understandable to the lay reader, although the details may be hard to follow if you don’t have a solid grounding in statistics, math or economics. Our one wish would be for more attention to the aftermath and the unprecedented bail-out orchestrated by U.S. financial regulators. But even in light of this shortcoming, getAbstract.com recommends this fascinating real-life market saga to general and business readers, and to anyone who ever comes anywhere near the financial markets.

Abstract

“In the virtual world of money, LTCM was aweinspiring. It was the pinnacle of a 30-year-long revolution in finance, which had done for trading and investment what the Apollo space program had done for lunar exploration.”

“While LTCM’s own partners were reckless or misguided, the real reason LTCM was so big and dangerous was because the people running the investment banks were greedy and ignored the risks.”

The Rise and Fall of LTCM Former Salomon Brothers Vice Chairman John Meriwether formed Long-Term Capital Management with Myron Scholes and Robert Merton — two Nobel Laureates who won their prize for their theory of option pricing — and a team of arbitrage traders. It returned fantastic 40% profits in 1995 and 1996, rewarded investors with $2.7 billion in excess capital in 1997, and increased its portfolio to $130 billion in assets and $1.25 trillion in derivatives in 1998. It began to collapse in the autumn of 1998, losing 90% of its value. At the same time, world market assets dropped $3 trillion. The effects are still felt internationally. To understand what happened, you need to know that capital managers use mathematical and computerized models to pull profits out of slight gaps in trading prices. LTCM’s model was based on certain assumptions about options, derivatives, futures and other obscure types of trading. It boomed because the world’s largest investment banks supported it, in part, because the bankers gave in to their greed and did not pay attention to potential risks. However, in 1998, Scholes and Merton’s theories stopped working, leaving government regulators and private bankers to organize a LTCM bail-out to avoid a potential global market collapse.

Financial Engineering The idea for a new type of options trading firm — a concept that became Long Term Capital Management — began when Boston-based financial consultant Fischer Black met Myron Scholes and Robert Merton, joint Nobel Prize winners for their rational theory of option pricing. Their notion became the basis of financial engineering, a way of mathematically understanding stocks, bonds and other securities that created a trilliondollar financial system. Inventing Money

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“There are two sides to options, which can be crudely labeled fear and greed. The fear aspect, more commonly known as risk, justifies their existence. The greed side, known as arbitrage, justifies their price.”

“The Black-Scholes-Merton theory contains the seeds of its own destruction. The most important assumption is that the underlying market such as stocks functions properly. In the summer of 1998, this and other assumptions would break down.”

“(Fischer) Black, (Myron) Scholes and (Robert) Merton had invented what came to be known as financial engineering. Just as the engineering of digital bits would eventually lead to the Internet, the mathematicallydriven engineering of stocks, bonds and other securities would create the modern trillion-dollar financial system.”

These ideas are rooted in the historical beginning of trading and the first use of money in the agricultural states of the Middle East thousands of years ago. The use of options dates back to Babylonia, 3,800 years ago, when lenders took risks based on the possibility of crop failures. But theoretical market models came into modern view in 1776, when philosopher Adam Smith developed a theory of markets that soon became popular in the U.S. As a result, statistics and mathematics helped shape thinking about markets. Key statistical measures that would become influential included the normal or bell distribution curve, a standard deviation measuring the spread of data or volatility. The Brownian motion theory also gained influence. It stemmed from the botanist Robert Brown’s observations about the random movements of dust particles, which led to the theory of the random walk — contending that the average distance a particle travels is proportional to the square root of the time it takes. In the early 1900s, Louis Bachelier applied this notion of movement to the unseen moods of thousands of traders and investors in the Paris stock market.

Markowitz, Sharpe, Black & Scholes In a revolutionary 1952 discovery, Chicago graduate student Harry Markowitz developed a theory about maximizing a stock portfolio’s total return and minimizing its volatility or risk to create an efficient portfolio. He later won a Nobel Prize for his efforts. William Sharpe, one of Markowitz’ students, was the first to show that you could correlate a particular stock with an index (such as the Dow Jones Industrial Average) to show if the stock was under-valued or over-valued compared to that index. This technique became known as the Capital Asset Pricing Model (CAPM). However, during the ‘50s and ‘60s, most fund managers and investment advisers were not thinking about these measures, although they eventually became part of the emerging field of financial economics. But, most investors still used traditional approaches to evaluate stocks, such as researching companies’ performance. In 1969, Black and Scholes created the Black-Scholes option pricing formula, based on the CAPM model. Their formula said that arbitrage could justify the price of an option by balancing fear or risk against greed about taking advantage of the option. The use of options developed into an elaborate system of practices where buyers and sellers met to trade grain options and future contracts. They engaged in calls, puts, hedging their exposures and trying to corner various markets. Black and Scholes provided a more precise way of getting rid of the risk of trading by indicating whether an option was fairly priced. Their formula helped traders own stock in the right balance against sold options, to protect against any market movement. Merton joined Black and Scholes in the 1970s and began testing their theory by applying it to warrants. They tried using the volatility that exists during the period of time before an option contract is agreed upon as a point upon which to measure the standard deviation of the stock price return. They found that it worked, and in time, their theory was used in a variety of other trades. The 1973 opening of the Chicago Board Options Exchange, which made it possible to trade stock options on an exchange, spurred investments in options.

Unlimited Options While Black, Scholes and Merton showed the importance of the idea of arbitrage, John Meriwether — who joined Salomon Brothers as a government bond trader in 1974 — turned arbitrage into a business. In the early 1970s, bond trading was a Wall Street backwater. Bonds were considered predictable and safe investments. Typically, bond Inventing Money


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investors bought new bonds issued by the government or a big company, got interest during the life of the bonds and then received back their full principal when the bond came due. However, the cost of the bond might vary, so that the interest yield might fluctuate. “On Wall Street in the 1950s and 1960s, no one could care less about financial economics. The majority of fund managers and investment advisers (then and now) took the traditional approach to picking stocks. They researched companies before recommending buying or selling.”

“Like the dust particles undergoing Brownian motion, the stock takes a random walk. All that’s left of the fund managers is the standard deviation, or volatility.”

“It was only after Black, Scholes and Merton completed the loop and showed how arbitrage could do this, that options broke out of obscurity.”

During Meriwether’s early years at Salomon, bond traders began to think of trading bonds in a new way, due to the ideas of Marty Liebowitz, head of bond research. Traders began to watch bonds’ different periods of maturity and to track the yield curve, predicting the eventual yield. They would then judge the movement as the shape of the curve changed due to bond prices, which thus changed yields. To out-guess the market — such as the market for U.S. Treasury Bonds — Meriwether began betting on how the curve would react. Soon he was in charge of a team of New York traders who bought and sold Treasury bonds, while he also led a team of pit brokers in Chicago who sold the equivalent T-bond futures. As the size of his trades increased, so did his profits. He hedged bond prices with futures to reduce any losses.

The New Mechanics In the late 1970s and early 1980s, other new financial mechanisms developed that expanded investment opportunities, such as currency swaps and interest-rate swaps, which became the most heavily traded derivatives internationally. Portfolio insurance was another mechanism, in which a computer program calculated when to buy and sell, based on protecting a portfolio from dropping below a fixed amount. Caps and floor options were developed, respectively, to stop the floating interest rate for bonds from rising above a certain level or dropping below it. By 1984, Meriwether was in charge of Salomon’s government bond divisions. He met a student of Merton’s, Eric Rosenfeld, who developed a theory based on ways an arbitrage trader could take a set of U.S. bonds with different yields and maturities, apply a systematic set of simultaneous equations and come up with the best price. The result would be a kind of profitable and riskless arbitrage. The process was very complex and mathematical, but essentially it was based on finding hidden options in the movements of the financial markets and determining what they were worth. Meriwether hired Rosenfield and soon added more traders and hired other academics to work with him. The theories seemed to work and produced increasing profits for Meriwether and Salomon, though the crash of October 1987 warned that mathematical models of human behavior might not always work. Problematically, key assumptions underlying Black, Scholes and Merton’s theories were incorrect. They were based on frictionless, continuous markets with limitless liquidity and on the idea that assets follow a random walk resulting in normal distribution. Meriwether ignored this potential problem, since he was doing well at Salomon, using tools like swaps and futures as well as a new “repo” tool that began as a wholesale, over-the-counter unregulated trade in Treasury bonds among investment banks. These tools let traders bet on floating interest rates without owning an actual bond or deposit account. By 1989, Meriwether and his arbitrage traders were making hundreds of millions in profits.

Busting The Models Then, in 1992, Meriwether left Salomon to create a hedge fund that would become LongTerm Capital Management. He invited the top members of his old Salomon arb team to join him. By August 1993, he had seven principles, including Rosenfeld, Merton and Scholes, who invested $150 million to launch the company, which they located in Greenwich, Connecticut, to get some distance from Wall Street. They basically worked Inventing Money


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“Call options allowed customers to buy or call a stock at a fixed exercise price in the future. Put options let them sell or put a stock back to the seller at a fixed price.”

“Black played around with the CAPM (Capital Asset Pricing Model) until he found an equation for options, which stated that the return on an option should be related to its volatility in a similar manner to the return on stocks.”

with a hidden network of friendly insiders and tried to be more like an investment bank than an ordinary hedge fund. Long-Term Capital took trading positions by owning bonds or being a counterparty in derivatives transactions. To minimize taxes and regulations, the company registered in the Cayman Islands under the administration of Mees Pierson, a Dutch financial services firm. LTCM asked investors for a 2% annual fee and 25% of profits. The fund’s managers made decisions using computer simulations. Their traders executed the trades and their strategists sought the best deals on swaps, options or bonds that met the computer specifications. In 1994, when LTCM was ready to launch, it had $1.5 billion and more than 100 employees. The firm added more computer modeled risk management tools, the VAR or Value at Risk — a control system that assessed potential downside risk — and Raroc, risk-adjusted return on capital. Supposedly, VAR and Raroc would purge unwanted risks as LTCM used its carefully applied leveraging techniques to earn towering profits. The premise was that, because of hedging, there would be less volatility, so LTCM could use leveraging to increase its position and therefore its return. LTCM raised extra capital to expand its position, based on its belief that the VAR limits and Raroc would catch any investment mistakes. Those assumptions were wrong. LTCM took in more and more capital from such investment sources as the Bank of Italy, Union Bank of Switzerland and Chase Manhattan, which put together a group of banks with more than $900 million in investment capital. These investors believed they could see big returns on the various options, currency trade and hedges to provide extra tax breaks. But once the world economy ran into problems in early 1997 in Southeast Asia, the house of cards began to fall. It undermined the European index options market, so short-dated European options began to rise sharply. The volatility of the market began to outpace the Black-Scholes formula and undermined expected profits. By 1998, losses were eroding LTCM’s core capital balance. By August 1998, LTCM had lost $2.5 billion, a victim of its own collateral management system based on hedging Treasury bonds by getting additional equity from hedge funds investors. Meanwhile, computerized programs based on a VAR analysis were spreading around the world, causing world markets to drop still more. Once the volatility increased beyond a certain point, they had no more money to hedge their option positions. Finally, in September 1998, LTCM closed for good.

About The Author Nicholas Dunbar studied physics in the United Kingdom at Manchester and Cambridge and in the U.S. at Harvard University, where he received a Master’s in earth and planetary sciences. After he left academia in 1990, he worked in feature films and television, and launched Flicker Films, a television production company. In 1996, he turned to finance and science writing, focusing on the derivatives industry. In 1998, he joined Risk magazine as its technical editor. He lives in London.

Buzz-Words Arbitrage / Arbs / Black-Scholes theory / Efficient portfolio / Options / Hedges / Quants / Repo / Swaps / Yields / VAR Inventing Money


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