Risk Management Lessons from Long-Term Capital Management

27 Pages Posted: 2 Aug 1999

See all articles by Philippe Jorion

Philippe Jorion

University of California, Irvine - Paul Merage School of Business

Date Written: June 1999

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 Classification: G11, G13, G14, G23

Suggested Citation

Jorion, Philippe, Risk Management Lessons from Long-Term Capital Management (June 1999). Available at SSRN: https://ssrn.com/abstract=169449 or http://dx.doi.org/10.2139/ssrn.169449

Philippe Jorion (Contact Author)

University of California, Irvine - Paul Merage School of Business ( email )

Campus Drive
Irvine, CA 92697-3125
United States
949-824-5245 (Phone)
949-824-8469 (Fax)

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