Reading notes -- Long Term Capital Management

Introduction:
Long Term Capital Management was a hedge fund founded by John Meriwether in 1994. Other famous members include two Noble Price winning economists, Myron Scholes and Robert C. Merton. They intended to exploit market inefficiency by using sophisticated pricing model like Black Scholes Merton’s option pricing model, in combination with high leverage. The hedge fund enjoyed great success in the first year, a 40% annual return, probably due to market inefficiency. However the good return didn’t last too long and the hedge fund lost $4.6 billion in 1997.

Notes:
Hersh Sherfrin, Heuristic- Driven Bias: The First Theme.
“Remember the Wall Street proverb about greed and hear? I note that the emotional aspect of aversion to ambiguity is fear of the unknown. The case of Long-Term Capital Management provides an apt example of this phenomenon. On September 23, 1998, a $3.6 billion private rescue of LTCM was arranged. The Federal Reserve Bank of New York orchestrated this plan because of a concern that the failure of LTCM might cause a collapse in the global financial system. The November 16, 1998, issue of the Wall Street Journal describe the scene as the participants departed the meeting at which the deal was struck The article attributes an interesting remark to Herbert Allison, then president of Merrill Lunch, a remark that typifies aversion to ambiguity as fear of the unknown. “As they filed out, they were left to ponder whether all this was necessary, and whether a collapse would really have jolted the global financial system. ‘It was a very large unknown,’ Merrill’s Mr. Allison says, ‘It wasn’t worth a jump into the abyss to find out how deep it was.’”

Hersh Shefrin, Inefficient Markets: The Third Theme.
One of the most fiercely debated questions in finance is whether the market is efficient or inefficient. Remember the hedge fund Long-Term Capital Management (LTCM)? How did it advertise itself to investors? LTCM members promoted their firm as an exploiter of pricing anomalies in global markets. In this regard, consider the following heated exchange between Myron Scholes, LTCM partner and Nobel laureate, and Andrew Chow, vice president in charge of derivatives for potential investor Conseco Capital. Chow is quoted as saying to Scholes, “ I don’t think there are that many pure anomalies that can occur”, to which Scholes responded: “As long as there continue to be people like you, we’ll make money.”
That last remark might not be the best way to win friends and influence people. But Scholes is correct about cause and effect – investors’ errors are the cause of mispricing. Is the market efficient?
The fact is that from 1994 through 1997, LTCM claims to have successfully made leveraged bets – bets that exploited mispricing identified by the option pricing theory for which Scholes and Merton jointly received the Nobel price. In this regard Merton Miller, another Nobel laureate, is quoted as having said, “Myron once told me they are sucking up nickels from all over the world. But because they are so leveraged, that amounts to a lot of money.” “Sucking up nickels” is indicative of inefficiency. Of course, then came LTCM’s 1998 fiasco, but more on that later….”
Overconfidence
There are many behavioral lessons in the saga of LTCM. It does appear that their early success can be attributed to the exploitation of mispricing. At the same time, mispricing does get reduced as investors trade to exploit the associated profit opportunities. And investor do learn, albeit slowly; thus profit opportunities that had existed in 1994 through 1996 in the derivatives markets dried up in 1997. In response, LTCM began to take other kinds of positions, such as bets on the movements of foreign currency movements. Myron Scholes is reported to have been critical of these trades, asking his LTCM colleagues questions like “What informational advantage do we have over other traders?”
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A Wall Street Journal article describing the experience of Long-Term Capital Management quotes Nobel laureate William Sharpe.
“Most of academic finance is teaching that you can’t earn 40 percent a year without some risk of losing a lot of money,” says Mr. Sharpe, the former Stanford colleague of Mr. Scholes. “In some sense, what happened is nicely consistent with what we teach.”