From: John Conover <john@email.johncon.com>
Subject: Re: LTCM and Low-Probability Events
Date: 20 Jan 1999 22:11:32 -0000
gchand4059@aol.com writes:
> Conover wrote:
>
> > So, if this is the case, it would be that the low-probability events
> > were not as low as expected.
>
> Obviously, they lost a bunch of money.
> Also isn't this like Murphy's Law: If something can go wrong - it will.
> And at the worst time.
>
Hi George. Yea, more or less. The attempt on derivatives, so the
story goes, is to consider it gambling, and play the odds-the
objective being to determine how often things can go wrong, so a
wagering strategy can be formulated.
Unfortunately, such a scheme requires a great deal of precision data
with meticulous analysis. For example, the 3 sigma hit rate mentioned
agreed with theoretical values to about 72 parts out of 6831, ie.,
only 72 samples were out of the expected distribution values of 6831
samples. Like I said, I don't know if this is what happened at LTCM,
or not.
The other issue is that derivatives are usually very highly leveraged
financial instruments. The implication being that a hedge company will
be vulnerable for the first few years of operations until it builds up
adequate equity in its investments to carry it through a downturn-ie.,
the company is gambling that it won't see a downturn in its first few
years of operation.
Not that derivatives are bad-international business and commerce could
not exist without them. LTCM is/was only one of many, and can not be
taken as an example-most hedge funds have fared well over the past few
years. Its really not clear at this time whether LTCM made any
mistakes-their fate could have been just the draw of the lottery.
John
--
John Conover, john@email.johncon.com, http://www.johncon.com/