LTCM’s Analysis of Risk Management February 28, 2002 Frank Burke Larry Kissko Gurkan Salk Heather...
-
Upload
felicia-lewis -
Category
Documents
-
view
219 -
download
0
Transcript of LTCM’s Analysis of Risk Management February 28, 2002 Frank Burke Larry Kissko Gurkan Salk Heather...
LTCM’s Analysis of Risk Management
February 28, 2002
Frank Burke
Larry Kissko
Gurkan Salk
Heather King
LTCM Risk Management
Agenda
1. LTCM Background
2. Swap Spread Trading Strategy
3. Project Analysis Comparison/measurement of LTCM’s Risk Assessment Discussion on return and spread distribution, calculated
implied std deviation Estimate of LTCM’s Value-At-Risk Proxy Tests
4. Take-aways
LTCM Risk Management
LTCM Background
August 21, 1998, fund lost $550m mostly from swaps spreads and equity volatility bets. LTCM believed this event would occur 1 in every 800
trillion years (or an 8.3 std dev move). Swap spreads shot up from 60 bps to 80 bps intraday vs. an
average daily move of 2 bps
LTCM’s swap position represented 2.4% of global swap market in December 1997
Leverage ratios varied from 28:1 to a high of 55:1 in late 1998
LTCM Risk Management
LTCM Trading Strategy
We focused on of one of LTCM’s biggest trades: Swap Spread Relative Value Trade
Swap spread – difference between the fixed rate on a fixed-for-floating swap and the yield on a coupon-bearing Treasury bond of comparable maturity
Speculative strategy that spread would converge to its historical mean
Long swap/short the treasuries (in 1998)
Crisis: Aug 21, spreads spiked 21 bps intra-day
LTCM Risk Management
Swap Spread Frequency: “the bet”Frequency through 7/31/98
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
30 36 42 48 54 60 66 72 78 84 90 96
Swap Spread
Freq
uenc
y
August 20, 88 August 21, 88
Upper 95%
LTCM Risk Management
Project Analysis
Parametric VAR – assumes normal distribution Historical VAR – based on actual data distribution Proxy search – difficult to find a strong correlation
BAA- 10 year treasury AAA- 10 year treasury MBS - 10 year treasury
Forecasted daily variance
Value At Risk – defined as the expected maximum loss over a target horizon within a given confidence interval
LTCM Risk Management
Swap Returns Distribution (thru 7/98)Frequency of Spread Returns through 7/31/98
0
200
400
600
800
1,000
1,200
1,400
1,600
-9.09% -6.71% -4.32% -1.93% 0.45% 2.84% 5.22% 7.61% 9.99% 12.38%
Spread % Return
Upper 99.85% based on Normal
Distribution
Upper 99.85% based on actual
distribution
LTCM Risk Management
Analytic Results
Risk analysis LTCM Satchmo
Return distribution
Normal Curve Non-normal:
w/Kurtosis & fat tails
99.7% confidence interval
[- 6.07%, + 6.10%] from the mean return 0.01%
[- 10.32%, +10.39%] from the mean return 0.01%
Implied Daily Std. deviation
2.03% 3.46%
Value at Risk (VAR) - estimated $60M $95.2M
Probability of Aug 21 event
10-13
Or .00000000001%
.16% = 4 observations over 10 year period
LTCM Risk Management
Value at Risk (VAR)
Principal measure of risk at LTCM LTCM parametric VAR measure
Capital (assume $1b) x daily std dev of returns (.02) x std dev of required confidence interval (3 = 99.85% 1-tail)
$1.0b x 2% x 3 = $60,000,000
Our historical VAR measure $ 1.0b x 9.5238% = $95,238,000
LTCM Risk Management
Take-Away Thoughts
VAR not necessarily suspect – correct inputs are critical
Cannot blindly apply normal distribution Dig into your data If data is not complete consider:
Developing a risk proxy Assuming fatter tails in distribution (Student’s T curve)
LTCM Risk Management
Appendix - chartsChange in Spreads
0
50
100
150
200
250
300
350
400
11/1
/88
5/1
/89
11/1
/89
5/1
/90
11/1
/90
5/1
/91
11/1
/91
5/1
/92
11/1
/92
5/1
/93
11/1
/93
5/1
/94
11/1
/94
5/1
/95
11/1
/95
5/1
/96
11/1
/96
5/1
/97
11/1
/97
5/1
/98
11/1
/98
5/1
/99
11/1
/99
5/1
/00
11/1
/00
5/1
/01
11/1
/01
Sp
rea
d (
in b
ps)
Swap Spreads Baa/Treasury Spreads Aaa/Treasury Spreads
August 21, 2002
LTCM Risk Management
Appendix - charts
Frequency through 2/20/2002
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
30 40 50 60 70 80 90 100 110 120 130 140
Swap Spreads
LTCM Risk Management
Appendix - chartsFrequency 7/31/98 - 2/20/02
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
58 64 70 76 82 88 94 100 106 112 118 124 130 136
Swap Spread
LTCM Risk Management
Appendix - chartsFrequency Of Spread Return through 2-20-02
0
200
400
600
800
1,000
1,200
1,400
1,600
% Price change
LTCM Risk Management
Appendix - chartsFrequency of Spread Returns after 7/31/98
0
50
100
150
200
-10.77% -8.35% -5.93% -3.51% -1.09% 1.33% 3.75% 6.17% 8.59% 11.01%
Spread Change
LTCM Risk Management
References
Jorion, P., 2000 Risk Management Lessons from LTCM Kolman, Joe, 1999, “LTCM Speaks”, Derivatives Strategy (April) p.12-
17 Lewis, Michael, 1999, “How the Egg-Heads Cracked” New York Times
Magazine, January 24, p 24-77 Anonymous, 1998, “Too Clever By Half”, The Economist Magazine,
November 14 Whaley, Robert, 2001, “Derivatives” Class Presentation Scholes, Myron, 2000, “Crisis and Risk Management- The Near Crash of
1998”, AEA Papers and Proceedings Vol 90 No. 2, May. Bloomberg – Swap spread data