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Financial Engineering: The Evolution of a Profession by Cara M. Marshall, Tanya Beder

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Chapter 21

Lessons from Funds: LTCM, Florida, and Orange County

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CASE STUDY ONE: LONG-TERM CAPITAL MANAGEMENT1

Event Summary

The significance of the events surrounding the collapse of Long-Term Capital Management (LTCM), and its subsequent loss of $4.4 billion, should not be underestimated. The breakdowns at LTCM include an overexposure to several types of risk: leverage, sovereign, model, liquidity, and volatility risk. In addition, the firm lacked the diverse revenue streams of the Wall Street investment banks to which it liked to compare itself. Overall, the fiasco portrays a failure of the firm to implement a broad-based risk management strategy and to properly stress test its models.

Event Details

Long-Term Capital Management was founded in 1994 and held a prestigious position in the unregulated hedge fund sector as a result of the reputations of its senior management, which included Nobel Prize winners Robert Merton and Myron Scholes. The hedge fund was founded by John Meriwether, who was previously head of fixed-income trading at Salomon Brothers until the firm was implicated in a government securities scandal. Meriwether brought some of the best minds with him to Long-Term Capital. The hedge fund's investors included many of the most prominent names in the financial services industry.

LTCM distinguished itself from the start with several years of above-average returns, which it earned from positions on interest rate spreads and market price volatilities. ...

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