...financial markets and in their theoretical depiction: it allows markets to be posited as efficient without all investors being assumed to be rational. This article explores the sociology of arbitrage by means of an examination of the arbitrageurs, Long-Term Capital Management (LTCM). LTCM’s 1998 crisis is analysed using both qualitative, interview-based data and quantitative examination of price movements. It is suggested that the roots of the crisis lay in an unstable pattern of imitation that had developed in the markets within which LTCM operated. As the resulting ‘superportfolio’ began to unravel, arbitrageurs other than LTCM fled the market, even as arbitrage opportunities became more attractive, causing huge price movements against LTCM. Three features of the sociology of arbitrage are discussed: its conduct by people often personally known to each other; the possibility and consequences of imitation; and the limits on the capacity of arbitrage to close price discrepancies. It is suggested that by 1998 imitative arbitrage formed a ‘global microstructure’ in the sense of Knorr Cetina and Bruegger. Keywords: arbitrage; economic sociology; imitation; Long-Term Capital Management (LTCM); globalization; risk. Introduction Of all the contested boundaries that define the discipline of sociology, none is more crucial than the divide between sociology and economics. Despite his synthesizing ambitions, Talcott Parsons played a critical role in reinforcing this...
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...Capital Management & Why They Failed? Prepared For: Mr. Ashek Ishtiaq Haq Course Instructor Financial Engineering Prepared By: Md. Zahidul Alam 19th Batch MBA Program Institute of Business Administration Jahangirnagar University Submission Date: April 26, 2013 Long-Term Capital Management (LTCM) was a very large hedge fund ($126 billion in assets) that nearly collapsed in late 1998. It reached that size because of its reputated owners. The founder was a Salomon Brothers trader, John Meriwether, and the principal shareholders were Nobel prize-winning economists Myron Scholes and Robert Merton. These were all experts in investing in derivatives to make aboveaverage returns and outperform the market. Investors paid $10 million to get into the fund. They were not allowed to take the money out for three years, or even ask about the types of investments LTCM used. Despite these restrictions, investors clamored to get in, thanks to LTCM's spectacular annual returns of 42.8% in 1995 and 40.8% in 1996. This was after management took 27% off the top in fees. LTCM successfully hedged most of the risk from the 1997 Asian currency crisis, giving its investors a 17.1% return that year. Trading Strategies: LTCM used complex mathematical models to take advantage of fixed income arbitrage deals usually with U.S., Japanese, and European government bonds. Price differences between a 30 year treasury bond and a 29 and three quarter year old Treasury bond is very minimal. However, small discrepancies...
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... Ethics and Honesty Dili Ethi dH t Part One: A NEW ERA Founding of LTCM LTCM was founded in 1994 by John Meriwether, the former vice‐ chairman and head of bond trading at Salomon Brothers t di tS l B th LTCM was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute‐ h l d b l return trading strategies combined with high leverage. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and hi i h B S d client relations were handled by Merrill Lynch. LTCM Partners John Meriwether Former vice chair and head of bond trading at Solomon Brothers; MBA, University of Chicago Leading scholar in finance; Prof. at Harvard Co-author of Black-Scholes model; Prof. at Stanford St f d Vice chairman of the Fed; Prof. at Harvard; Arbitrage g p at Salomon; former Harvard g group ; Prof. Arbitrage group at Salomon; former Harvard Prof. Arbitrage group at Salomon; Ph D MIT Ph.D. Arbitrage group at Salomon; Ph.D. MIT Bond trader B dt d Executive at Salomon Arbitrage group at Salomon; Master in Finance, LSE Robert C. Merton Myron Scholes David W. Mullins Eric Rosenfeld William Krasker Gregory Hawkins Larry Hilibrand James M E t J McEntee Dick Leahy Victor Haghani Performance Year Return* 1994 19.9% 1995 42.8% 1996 40.8% 1997 17.1% 1998 -98.3% LTCM earned $2.1bn in 1996 while Morgan Stanley 1bn Stanley 1bn LTCM charged management fees @2% and performance fees d f f @25%, higher than ...
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...COMPANY: Long Term Capital Management OVERVIEW: The following Case Study addresses an amazing Company called “Long Term Capital Management” (LTCM). This is a fascinating story of big time business and the ignored impact of the omnipresent timeless, Ten Early Warning Signals. These Signals can be controlled and converted into profitable success or perilously ignored at the risk of losses and eventual failure. DATE PREPARED: July 4, 2007 CASE STUDY PREFACE During our three decades of “hands on” Business Survival Consulting” assignments we would constantly push to improve Client profitability. Profit Improvement in one form or another is, of course, the foundation of a successful turnaround. During this process we clarified and expanded upon three axioms that, to a greater or lesser degree, are generally unknown and/or certainly under utilized in the quest to improve corporate profitability in American Business. These three axioms are: AXIOM ONE: “Key People Know” Who knows a company better than the key people in a company? Nobody does! The collective knowledge of key personnel, if properly focused and channeled, can be an omnipotent Profit Improvement force for top management in their Profit Improvement efforts. AXIOM TWO: “Crisis Avoidance and/or Crisis Correction” constitutes the basic operating environment of most “for profit” companies. In its most simple approximation, 20% of Businesses are generally crisis free. The next 60% of Businesses are involved in a series of minor...
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...TABLE OF CONTENT WHAT IS A HEDGE FUND? 1 WHAT GENERIC HEDGE FUND HAS SIMILAR LEVERAGE CHARACTERISTICS TO BANKS? 2 DO ALL HEDGE FUNDS HAVE A SIMILAR RISK PROFILE? IF NOT DESCRIBE THE TYPE OF RISK FACING EACH MAIN TYPE OF HEDGE FUND 3 More Risky 3 Moderate Risk 3 Risk-Avoidance 3 WHAT FINANCIAL RISKS LED TO FAILURE OF LONG-TERM CAPITAL MANAGEMENT (LTCM)? 4 WHY DID THE FEDERAL RESERVE OPT NOT TO SUPPORT LONG-TERM CAPITAL MANAGEMENT FINANCIALLY? 5 WHAT WERE THE ARGUMENTS IN FAVOUR AND AGAINST THE RESCUE OF LONG-TERM CAPITAL MANAGEMENT? 6 Arguments for the rescue of LTCM: 6 Arguments against the rescue of LTCM: 6 WHAT TYPE OF FINANCIAL INVESTOR WAS DIRECTLY AFFECTED? WHAT WAS THE POTENTIAL INDIRECT EFFECT OF THIS CATEGORY INVESTOR FAILURE? 7 DOES THE RESCUE OF INSTITUTIONS LABELLED “TOO BIG TO FAIL” 9 Strengthen the long term stability of financial services sector? If so, how? 9 Encourage excessive risk taking in the knowledge of an implicit “safety net”? If so, explain why 9 WAS THIS A CASE OF CRONY CAPITALISM? 10 REFERENCES: 11 WHAT ARE HEDGE FUNDS? Hedge funds are private investment funds that aim to make profits for their shareholders by trading securities. Hedge fund utilises a variety of financial instruments to reduce risks, enhance returns and minimise the correlation with equity and bond markets. They are flexible in their investment options and can use short selling, leverage, derivatives and arbitrage. Hedge funds are defined by...
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...Briefly explain the rise and fall of LTCM. What was the moral hazard issue the fed was worried about? How did they try and get around the moral hazard issue? What specifically was the Fed's role in the bailout? What roles specifically did Bear play and not play in the LTCM's life and death? LTCM’s board of directors included many geniuses in from the financial world, who collectively created complex models allowed them to calculate risk of securities much more accurately than others. LTCM’s trading strategy was featured by the divergence in price between long-term U.S. Treasury bonds. It shorted the more expensive “on-the-run” bond and purchased the “off-the-run” security at the same time to exploit the price divergence. In order to boost its returns, LTCM employed massive leverage, borrowing more than $124.5 billion. However, this strategy was not sustainable enough to earn profits. First of all, market lacked the sufficient capacity to absorb such a great size of investment. Secondly, the high leverage made LTCM vulnerable to market fluctuations. After Russia default on its government-issued bonds, panicked investors flight to quality assets like the US Treasuries while selling the risky securities in which LTCM trade, and further prevented the price convergence which LTCM bet on. At this time when LTCM heavily relied on leverage, Bear Stearns stopped to act as a clearinghouse for the fund’s trades, further worsened the situation of LTCM. When other major investment banks...
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...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...
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...Table of Contents 1. Introduction 1 2. Analysis for problems associated with using models 1 2.1. Model error 1 2.1.1. Wrong or simplifying assumptions 1 2.1.2. Over dependence on historical data 3 2.1.3. Black swans 4 2.2. Implementing a model wrongly 4 3. Improvements of the usage of models 5 4. Conclusion 7 1. Introduction The financial sector plays crucial roles that mobilize savings and allocate credit in economic performance. In recent years, there has been significant technological development within the financial sector, which has enable banks to effectively manage their internal risk through the application of risk models. The use of models to measure risks is the preferred approach by most banks, for example Goldman Sachs applies the Value at Risk model. However, according to Office of the Comptroller of the Currency (2011, p1), “the expanding use of models in all aspects of banking reflects the extent to which models can improve business decisions, but models also come with costs”. Besides, in a recent study (Jorion 2009), it is argued that many financial institutions experienced large losses over the past few decades due to limitations of using sophisticated models. Therefore, it is essential for Andrew Bank Ltd. to have an in-depth understanding of disadvantages relating to using models and solutions to improve these model risks. 2. Analysis for problems associated with using...
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...Edited by Foxit Reader Copyright(C) by Foxit Software Company,2005-2007 For Evaluation Only. Fisher College of Business Working Paper Series Charles A. Dice Center for Research in Financial Economics Risk Management Failures: What Are They and When Do They Happen? René M. Stulz, Department of Finance, The Ohio State University, NBER, and ECGI Dice Center WP 2008-18 Fisher College of Business WP 2008-03-017 October 2008 This paper can be downloaded without charge from: http://www.ssrn.com/abstract=1278073 An index to the working paper in the Fisher College of Business Working Paper Series is located at: http://www.ssrn.com/link/Fisher-College-of-Business.html fisher.osu.edu Risk management failures: What are they and when do they happen? René Stulz* October 2008 Abstract A large loss is not evidence of a risk management failure because a large loss can happen even if risk management is flawless. I provide a typology of risk management failures and show how various types of risk management failures occur. Because of the limitations of past data in assessing the probability and the implications of a financial crisis, I conclude that financial institutions should use scenarios for credible financial crisis threats even if they perceive the probability of such events to be extremely small. * Reese Chair of Banking and Monetary Economics, Fisher College of Business, Ohio State University, NBER, and ECGI. I am grateful for assistance from Jérôme...
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...Investment Banking in 2008 (A): Rise and Fall of the Bear 1. What role did Bear’s culture play in its positioning vis-à-vis its competitors, and what role might that culture have played in its demise? Bear Stearns played a risky role with the promise of high returns. Bear was participating in the LTCM and created a bubble. Bear’s competitors recognized and hedged against risk by participating in the buyout while Bear Stearns ignored the bullish market. Other banks hired both externally as well as internally so they received other opinions and perspectives, but Bear Stearns only hired internally. Bear ignored concerns while others hedged for possible risk. While all the banks were losing money from CDO’s, Bear’s losses were the most looked at and brought the most fear. 2. How did Bear’s potential collapse differ from that of LTCM in the eyes of the Federal Reserve? Bear Stearns had a chance to contribute to the bail out which may have saved them. The LTCM demanded high returns and the market could not satisfy these expectations. Bear should have learned from the LTCM collapse so one thing that differed is the banks had more knowledge after the collapse and should have done things differently. Also, it was a less turbulent market when Bear collapsed. 3. What could Bear have done differently to avoid its fate: 1. In the early 2000s? In the early 2000s, Bear Stearns tried to issue shares that were later called “toxic waste” so the bank...
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...CEO Toolkit n GLOBAL CEO n January 2003 A CEO’s guide to value at risk models Ravi Madapati* Value at Risk (VaR) models are being used extensively in the world of risk management. VaR provides an upper bound on the potential loss due to adverse market fluctuations. VaR can be used to estimate risk in the case of various financial instruments including bonds, equities and derivatives. S ince the past decade or so no other tool in financial risk management has been heard about as much as Value at Risk (VaR) modeling. VaR has rapidly become the industry standard for measuring and reporting market risk in trading portfolios of banks and other trading institutions. VaR provides an upper bound on the potential loss due to adverse market fluctuations. Any VaR number has to specify which portfolio is being considered (e.g., Equity derivatives book), the confidence level (e.g., 97.5%) and the holding period (e.g., 10 days). VaR objectively tries to combine the sensitivity of the portfolio to market changes and the probability of a given market change. VaR has been adopted by the Basel Committee to set the standard for the minimum amount of capital to be held against the market risks. VaR can be used to estimate risk in the case of various financial instruments including bonds, equities and derivatives. VaR can be used to communicate risk and to control risk by setting limits for frontline traders and operating managers. Pros and cons of using VaR...
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...Financial Risk: Key Fundamentals and Case Studies Leonard Chumo, CFA, FRM Strathmore University GARP Chapter Meeting 29th July 2011 Agenda 1. Background 2. Credit Risk and the Case of Washington Mutual 3. Operational Risk and the Case of Rogue Brokers in Kenya and Barings 4. Market Risk and the Case of LTCM 5. Liquidity Risk and the Case of Northern Rock 6. Q&A BACKGROUND Main Types of Financial Risk Risk Type Definition Credit Risk The potential that a bank's borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Market Risk The risk that movements in market prices will adversely affect the value of on- or off-balance sheet positions. The risk is attributable to movements in interest rates, foreign exchange (FX) rates, equity prices or prices of commodities. Operational Risk Risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition includes legal risk, but excludes reputational and strategic risk. Liquidity Risk Liquidity is the ability to fund increases in assets and meet obligations as they become due. It is crucial to the ongoing viability of any organization. Source: Financial Stability Institute CREDIT RISK AND THE CASE OF WASHINGTON MUTUAL Sources of Credit Risk Apart from traditional types of loans, credit risk can also be found in a bank's: Investment portfolio ...
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...Demystifying T 20 The Milken Institute Review The Merriam-Webster dictionary defi nes a derivative in the fi eld of chemistry as “a substance that can be made from another substance.” Derivatives in fi nance work on the same principle. These fi nancial instruments promise payoffs that are derived from the value of something else, which is called the “underlying.” The underlying is often a fi nancial asset or rate, but it does not have to be. For example, derivatives exist with payments linked to the S&P 500 stock index, the temperature at Kennedy Airport, and the number of bankruptcies among a group of selected companies. Some estimates of the size of the market for derivatives are in excess of $270 trillion – more than 100 times larger than 30 years ago. When derivative contracts lead to large fi nancial losses, they can make headlines. In recent years, derivatives have been associated with a few truly notable events, including the collapses of Barings By René M. Stulz Financial Derivatives Third Quarter 2005 21 Bank (the Queen of England’s primary bank) and Long-Term Capital Management (a hedge fund whose partners included an economist with a Nobel Prize awarded for breakthrough research in pricing derivatives). Derivatives even had a role in the fall of Enron. Indeed, just two years ago, Warren Buffett concluded that “derivatives are fi nancial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” michael...
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...Gregory Connor and Mason Woo An Introduction to Hedge Funds Introductory Guide 1 Introduction International Asset Management (‘IAM’) is the proud sponsor of the IAM Hedge Fund Research Programme of the Financial Markets Group. Within this programme the LSE team undertakes independent research into aspects of the hedge fund industry. It is hoped that the results of this research will give greater understanding about this growing area of financial innovation. This research paper gives a broad introduction to the hedge fund industry, the historical background to the evolution of hedge funds, the fund of funds industry and provides an explanation of some of the terminology used within this area. As an overview of the industry the document does not attempt to address the use of hedge funds within the broader context of portfolio management such as organisational risk or other areas of concern for the investor. This is a nontechnical paper and as such is intended for students or practitioners seeking a general introduction and reference tool. It is not a survey of the research literature and citations are kept to a minimum. If you wish to keep updated on the IAM Hedge Fund Research Programme please let us know. If you have any questions please contact IAM at our London office or visit our website: 34 Sackville Street London W1S 3EF Tel. +44 (0)20 7734 8488 www.iam.uk.com For information about the research activities of the Financial Markets Group see the following page...
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...Organizations And External Environment Have you ever imagined yourself as a leader of a huge or small organization ? Which decisions would you make to guarantee a high efficiency of work ? I know that you feel that it may be easy to successful. It's just a decision-making and some employees who need someone to command them. Sitting behind large offices is a dream target for many employees, but to achieve this goal you need not only a hard work, but a high level of knowledge. Neglecting a simple thing could lead to the end. Over years many companies suffered from losses while others had already collapsed and did not exist anymore. There were many different reasons behind these problems. Some companies ended due to the competition with other firms. Others gave up because their products are no longer desirable. Most these firms figured out the main reasons of the problems too late. Many employers focus on internal environment more than the external environment or they would not pay attention to the outer boundaries. They may believe that the external environment is something you can’t control or deal with. For example, they look after good staff, great services, high quality of products ,appropriate structure…etc. All these issues manage and handle internal environment of the organization. Unfortunately, many firms somehow or another neglect external factors which could also affect negatively their business. Many companies went out of the market just because of the impact...
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