In September 1997, the Fund had an annualized standard deviation of approximately 10.7%, which was significantly lower than the Fund’s long-run goal of 20% annualized standard deviation. There are several reasons to explain why LTCM had difficulties in raising its level of risk.
LTCM structured the majority of its trades in a way that required minimal initial outlay of capital. Furthermore, most of the Fund’s contractual trade agreements were self-financing. This 100% financing combined with the long-short structure of the Fund affected the methods of risk assessment and risk management employed by the firm. One important aspect of the resulting risk assessment methods of LTCM was the fact that trades based on widening price discrepancies would generally attract more capital from investors and arbitrageurs. This influx of further capital usually resulted in lower downside risk on trades as valuations became more extreme.
However, in our opinion the most important factor affecting LTCM’s ability to raise its level of risk is the correlation analysis methods used by the firm. Over the long-term one-year horizon, the firm based its correlation analysis on the fundamental factors that affected trades. When looking at the fundamental risk factors affecting these positions, the majority of the long-term trades were largely uncorrelated and therefore resulted in very low levels of risk. When calculating correlation for short-term trades, LTCM included price movements that resulted from the short-term liquidity needs of traders. The firm adopted a conservative approach and assumed that many of these positions were positively correlated, however this still did not lead to an increase in the overall risk levels of the Fund.
Value at Risk is a method used by many financial institutions to measure levels of risk in terms of a...