In the LTCM fiasco, the effort to conquer markets through derivatives ultimately failed.
The historical development of option pricing theory, starting from Louis Bachelier and Albert Einstein.
LTCM's challenges included the Russian financial crisis, leverage, and dependence on counterparties.
Deep dives
Background of LTCM and Nicholas Dunbar's Expertise
Nicholas Dunbar, author of Inventing Money, discusses the LTCM fiasco and its valuable lessons. With a background in math and physics, Dunbar is well-equipped to explain how LTCM's effort to conquer markets through derivatives ultimately failed.
The Development of Option Pricing Theory
Dunbar explains the historical development of option pricing theory, starting from the work of Louis Bachelier and Albert Einstein. He discusses the contributions of Fischer Black, Myron Scholes, and Robert Merton, and how their groundbreaking work led to the creation of the Black-Scholes-Merton formula.
LTCM's Successes and Expansion
Dunbar explores LTCM's early successes, including their convergence trades in European government bonds and their involvement in equity volatility trading. He highlights the strategic relationships and partnerships that helped LTCM grow and become a major player in the financial markets.
The Unwind and Challenges Faced by LTCM
Dunbar details the challenges faced by LTCM, including the Russian financial crisis in 1998 and the subsequent market turmoil. He discusses how LTCM's leveraged positions and dependence on counterparties led to the rapid deterioration of their portfolio and the need for a bailout.
Lessons Learned and Impact on the Financial System
Dunbar reflects on the aftermath of the LTCM crisis and its impact on the financial system. He highlights the importance of risk management, the dangers of crowded trades, and the role of central banks in mitigating systemic risks. He also draws parallels between LTCM and the 2008 global financial crisis.
I like to say that you learn the most in markets by studying the periods when things go horribly wrong. And in this spirit, Alpha Exchange guests are often asked to reflect back on risk events of great consequence. 2023 marks the 25th anniversary of the LTCM fiasco, an event too long ago to matter for anyone under the age of 40, even as there are valuable lessons to be had from this giant portfolio unwind. As we look back on this vol event from 1998, it was a pleasure to welcome Nicholas Dunbar, author of “Inventing Money: The Story of Long Term Capital”, to the podcast. With a background in math and physics and with a long stint at Risk Magazine, Nick was well equipped to explain how the effort to conquer markets through the science of derivatives ultimately failed. Along the way, he provides a brief history of how option theory has developed, brings to life key players in the story and dives in to technical details of LTCM’s trades. We learn about the dangers of models, leverage, hubris and crowding all at once. I hope you enjoy this episode of the Alpha Exchange, my conversation with Nick Dunbar.
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