2. Identify the risk management issues illustrated by the case.
Risk Management Failures
For a time during fall 1998, hedge funds seemed to be on the front page of every newspaper in the world. Investors in some hedge funds had taken huge losses following the collapse of the Russian economy in August, and the Federal Reserve felt it necessary to organize a rescue of a hedge fund called Long-Term Capital Management. The following policy and regulatory issues are raised by the LTCM debacle.
First, even when the LTCM know the examples about the possibility of losses in less liquid positions, the LTCM’s risk managers ignored the severity of the jump in credit spreads and the liquidity crisis instead of using flight-to-quality model to fix it. The worse is it still utilizing the same covariance matrix to measure risk and to optimize positions inevitably results in biases in the measurement of risk.
Second, the LTCM did not have suitable strategy to deal with the situation that there are other players held similar relative-value bets and that interrelations between them tend to vanish due to the market stress. It did nothing except using the same strategy to take positions that appear to generate “arbitrage” profits based on recent history but also represent bets on extreme events, like selling options.
Third, according to the fund’s Value at risk (VAR) and the amount of capital necessary to support its risk portfolio, the LTCM’s strategies are analyzed, and illustrates that LTCM had seriously underestimated its risk due to its over reliance on risk concentration and VAR which even defective and even be dumped by other firms.
Fourth, the LTCM is still not clear that the data gathering is not root methodology to predict the future crisis. Furthermore, relative-value traders of LTCM used to avoid risk limits, which it contrast to the other firms using risk limits to