The Regional Economist

JULY 2002

Even Nobel Laureates Can Be Tripped Up By Uncertainty

Return to main story

Long-Term Capital Management (LTCM) was a hedge fund known for the extraordinary talent of its traders and research staff. Among the partners of LTCM were Robert Merton and Myron Scholes, who share the 1997 Nobel Prize in Economics for their work on securities pricing. Merton said that LTCM "attempted to marry the best of finance theory with the best of finance practice," recounted Roger Lowenstein in his 2000 book, When Genius Failed: The Rise and Fall of Long-Term Capital Management.

Hedge funds try to profit from temporary market inefficiencies that manifest themselves in securities mispricing. By owning comparatively underpriced securities and owing comparatively overpriced securities, hedge funds record capital gains when the price difference (spread) between the two securities narrows. Lowenstein recounts Myron Scholes explaining LTCM's trading strategy as "earning a tiny spread on each of thousands of trades, as if it were vacuuming up nickels that others couldn't see." Within four years, a dollar invested in the hedge fund quadrupled. To generate such high return on tiny spreads, LTCM put on very aggressive trades.

In the summer of 1998, in the wake of the Russian default on ruble-denominated debt, LTCM blew up rather spectacularly. In fact, LTCM pushed the world financial system to the brink of collapse when its liquidity dwindled and large hedge portfolios in securities markets around the world were on the verge of being closed out in a fire sale. The Federal Reserve Bank of New York orchestrated (not financed, that is) a financial workout that allowed LTCM to unwind its portfolios in an orderly manner.

What happened? As Nobel laureate Merton Miller stated, "In a strict sense, there wasn't any risk--if the world had behaved as it did in the past."1 In other words, LTCM had taken due account of risk, but not uncertainty. LTCM did not factor in the possibility that the way it thought about financial markets was flawed. (In the end, two of its partners won the Economics Nobel Prize during their tenure at the fund.)

LTCM was brought down by an event unprecedented in the modern history of emerging markets. In past financial crises in emerging countries, governments defaulted on debt denominated in foreign currency before defaulting--if at all--on debt denominated in local currency. (This is because a government can always print more of its own currency to finance its outstanding debt.) In the summer of 1998, things were different. Russia defaulted on domestic debt, without defaulting on foreign debt. Moreover, Russia issued a moratorium on bank payments. As a result, hedge funds that had been long on the high-yielding Russian domestic debt, and had hedged these positions by short sales of Russian foreign debt and forward sales of ruble to Russian banks, were caught off guard as neither hedge worked.2

ENDNOTES | REFERENCES

Back to the top