Risk Management Lessons from Long-Term Capital Management

Abstract:     
The 1998 failure of Long-Term Capital Management (LTCM) is said to have nearly blown up the world's financial system. For such a near-catastrophic event, the finance profession has precious little information to draw from. By piecing together publicly available information, this paper draws lessons from risk management practices at LTCM.

LTCM's strategies are analyzed in terms of the fund's Value at Risk (VAR) and the amount of capital necessary to support its risk profile. The paper shows that LTCM has severely underestimated its risk due to its reliance on short-term history and risk concentration. LTCM also provides a good example of risk management taken to the extreme. Using the same covariance matrix to measure risk and to optimize positions inevitably leads to biases in the measurement of risk. This approach also pushes the strategy to take positions that appear to generate ``arbitrage'' profits based on recent history but also represent bets on extreme events, like selling options. Overall, LTCM's strategy exploited the intrinsic weaknesses of its risk management system.

JEL Classifications: G11, G13, G14, G23

Working Paper Series