PBS series NOVA explains how LTCM Hedge Fund almost collapsed the global economy.

"Trillion Dollar Bet" - Original broadcast date: 02/08/2000

In 1973, three brilliant economists, Fischer Black, Myron Scholes, and Robert Merton, discovered a mathematical Holy Grail that revolutionized modern finance. The elegant formula they unleashed upon the world was sparse and deceptively simple, yet it led to the creation of a multi-trillion dollar industry. Their bold ideas earned Scholes and Merton a Nobel Prize (Black died before the prize was awarded) and attracted the elite of Wall Street.

In 1993, Scholes and Merton joined forces with John Meriweather, the legendary bond trader of Salomon Brothers. With 13 other partners, they launched a new hedge fund, Long Term Capital Management, which promised to use mathematical models to make investors tremendous amounts of money. Their money machines reaped fantastic profits, until their theories collided with reality, and sent the company spiraling out of control. The crisis threatened to bring markets around the world to the brink of collapse.

Theory behind the formula

-- Alan Greenspan (@ .), February 09, 2000

Answers

So, when we hear the Goldman Sachs could be on shaky ground, one has to wonder about the possibilities, ey?

One thing that is inevitable is that what goes up must come down. Cycles cannot be manipulated forever.

I invite any mathemetician to prove otherwise.

-- OR (orwelliator@biosys.net), February 09, 2000.

Alan G.

Thank you for helping with the show, very interesting information. I noticed you even had one of your minions on discussing the matter. No doubt we have not heard the last of this situation.

By the way I want to get some help on some Y2K losses involving going long on tuna and shorting my attention span. This has caused a 300 billion $$ dislocation in world markets and blisters on my fingers from typing. If we could work out a rescue package to balance out my affairs I would be gratefull.

Thanks.

-- Brian (imager@home.com), February 09, 2000.

Ah, sorry Brian, but we only bail out multi-billionares...

(BTW...the minimum investment in LTCM was $100,000,000.00 for at least three years...)

-- Alan Greenspan (@ .), February 09, 2000.

Hmmmm...

From that "Theory behind the formula" link:

...Believe it or not, you can still match its future payoff by creating a replicating portfolio. However, to do so you must buy a fraction of a share of the stock and borrow a fraction of the exercise price. How do you know what these fractions are? That is what the Black-Scholes Formula tells you.

It states that the price of the call option, C, is equal to a fraction -- N(d1) -- of the stock's current price, S, minus a fraction of the exercise price. The fractions depend on five factors, four of which are directly observable. They are: the price of the stock; the exercise price of the option; the risk-free interest rate (the annualized, continuously compounded rate on a safe asset with the same maturity as the option); and the time to maturity of the option. The only unobservable is the volatility of the underlying stock price...

If I understand that comment, volatility must therefore be estimated and is thus the wild card. That would seem to indicate that current market conditions are really playing havoc with the models (and the billions of dollars they guide) based on this formula. *ouch*

-- DeeEmBee (macbeth1@pacbell.net), February 09, 2000.

I read the LTCM top guy started another firm, with horrible credit ratios,equally risky...some congressmen got upset but nothings been done....don't hear this on the USA Pravda media either.

-- carolyn (carolyn@luvmyhub.com), February 09, 2000.