One of the most dramatic - and embarrassing - financial debacles of recent times was the collapse in 1998 of a very hot Wall Street venture called Long Term Capital Management (LTCM). This was a company employing Nobel Prize winners (Robert Merton and Marvin Scholes) that was built on Novel Prize winning ideas - that financial markets are perfectly efficient; that the value of financial equities as traded financial markets reflect the true value of the underlying assets; that with very little basic data, investors can accurately price the value of equities using the Black-Scholes equations. The collapse of LTCM and its impact on the whole financial system are described in Lowenstein's best-selling book, When Genius Failed (2001).
Explain what it means to say that financial markets are perfectly efficient. (one-half to one page)
If financial markets are indeed perfectly efficient, what implications does this have for the theory and practice of finance? (one page)
Offer a critique of the idea that financial markets are perfectly efficient. How did pursuit of this belief ultimately harm LTCM? (one to two pages)
What went wrong at LTCM? Why was it that after three enormously successful years, they suddenly lost a fortune and almost took Wall Street down with them? (target two pages)
To say that financial markets are perfectly efficient is one of the most important assumption or hypothesis in modern finance, especially the portfolio theories. This type of efficiency can be related to Efficient-market hypothesis which was developed by Eugene Fama at University of Chicago Booth School of Business.
The efficient-market hypothesis was first proposed by a French mathematician, Louis Bachelier. His work was unfortunately ignored. Until the 1950s, a number of studies showed that stock prices followed a random walk model. Researches also suggested that professional investors were in general unable to outperform the market. The efficient-market hypothesis was then further developed by Fama as an academic concept of study through his published Ph.D. thesis in the early 1960s.
There are three forms of market efficiency. They are "weak form", "semi-strong form", and "strong form". The weak form of the efficient-market hypothesis assumes that prices on traded assets like stocks, bonds, and property had already reflected all past publicly available information. Under this proposition, traders cannot take benefit from technical analysis or behavioral theories.
The semi-strong form supposes that prices had reflected all publicly available information and instantly change to reflect new information. This proposition means that professional investors cannot outperform the market by fundamental analysis.
The strong version supposes that market reflects even hidden/inside information. Insider cannot take advantages on the financial markets.
The perfect efficiency here should include the strong form efficiency as most of the financial theories were built on this assumption.
Moreover, a perfectly efficient financial market includes the characteristics of perfect competition like zero transaction cost, large number of rational investors and etc.
There are numerous theories built on the assumption that the real financial markets are perfectly efficient, for example, the Black-Scholes option pricing model, risk-neutral pricing model, Capital Assets Pricing Model and etc.
The assumption of perfect efficiency indeed makes a clear path for modeling the behavior of investors. It simplifies the investment decision as if every people got all information about the stock. All stock prices are accurately trading and people could execute the most optimal decision based on their own risk appetite. The only decision making methodology enables the economists to build the basic portfolio theory and rationalize the statistical assumption.
Unlike conventional fixed income securities, stocks are unpredictable due to its characteristics like that the future cash flows are unpredictable. However, inside this perfect financial world, everything could then be modeled by simple mathematics and statistics. Those mathematical formulas could also allow people to understand more about the behavior and changes of the financial markets.
Regarding pricing strategies, under the assumption of perfect efficiency, securities can be easily priced as it could be believed all securities are correctly priced. We can easily compare the stock by simple accounting ratios like P/E, ROA, ROE, and etc. We could also predict the future dividends of the stock and price the stock like fixed income securities.
Having known the price of the securities, other characteristics like risk could also be modeled. Risk management science could be easily developed as the risk factors could be modeled by statistics. Moreover, the pricing model enables the extension of financial securities. Derivatives such as options and futures or advanced structure product could be priced using advanced mathematical skills or modern computational power. These different financial instruments further enriched the risk management technique as the exposure can be easily controlled and different hedging strategies could be available for different risk factors.
The development of CAPM or portfolio theories also created other aspects of study like performance measurement. Sharpe ratio and Treynor ratio are the most popular portfolio performance evaluation. They were also built on Capital Asset Pricing Model which has assumed the financial market to be perfectly efficient. These measurement ratios enable investor, senior management to understand the performance of the fund, the fund manager and individual securities in the portfolio. They can, in addition, allow investor to pick out-performing stock over the market.
In general, the assumption of perfectly efficient market has contributed a lot to modern financial theory and the development to financial industries. It enables people to quantify the characteristic, including risk and return, of all securities. The assumption allows people to clear the uncertainty about stock market. Furthermore, with the development of the internet, the assumption of perfect information is becoming increasingly valid as information is now cheaper to obtain, unlike those age without computer or electronic devices.
However, even with the ease to grasp stock related information, the exposure of the private information is practically impossible due to timing difference and the management decision of the company. The workers and senior management always either reach the material information first or make the crucial decision. Whenever they have controls of the company, it is inevitable to have the advantages.
Moreover, being a rational investor requires professional knowledge that not everyone can learn the investment techniques like fundamental analysis, technical analysis, portfolio optimization, hedging strategies and etc. They cannot always make the optimal investment decisions. What's more, everyone have their own expectation over the market, economy, and etc. There is no unified investment decisions that suit everyone's desire.
And obviously, the transaction cost can never be zero as operation cost counts. Empirical studies have proven the impact of transaction costs on market efficiency. Any anomalies due to market inefficiencies are the consequence of the cost benefit analysis of those willing to incur the cost of information.
In addition, the expectation of the market participants changes quickly. Trading at the time of forming asset bubbles will cause serious misjudgments no matter buying or short-selling the assets as people usually become increasingly irrational and uncontrollable due to herding behavior. At these moments, people own securities always win money. This made the friends, relatives, or other people jealous and started to enter the market.
Market liquidity is also a critical component of inefficiencies. The trading volume is limited and even low for some sorts of securities. Typically, at the worst economic condition, after the breakout of any bad news about the economy, the market even freeze as no one is willing to buy the financial assets.
There are lots of arguments to disprove the assumption of market efficiency. To conclude, the assumption of perfect efficiency is unrealistic, though it is a known fact. LTCM, those Nobel Prize winners, university professors still believed in the assumption and used them in practice to trade securities which is something unbelievable.
Unfortunately, apart from those solons, many fund managers or traders are also using these models like Black-Scholes model to trade different types of options. Without solid foundation, the theory cannot explain too much about the financial world. Even the securities are trading at the theoretical prices; it does not necessarily mean that their returns or the value of the assets are guaranteed.
When one of the assumptions went off seriously, this will severely affect the cash flow or return model of the portfolio held. The liquidity problems will further bring them into dead end. The buy and hold strategies cannot be used due to the shortage of cash and regular expenses.
The risk management also cannot offer help in extreme market conditions as those risk management model always built on the assumption of efficient market. Hedging or stop-loss strategies may not always work.
To conclude, trading at the assumption of perfect market efficiency can ultimately harm the company of the whole investment portfolio. There are a lot of example we can reference to in the history like what happened to LTCM.
Long-Term Capital Management (LTCM) was founded in 1994 by John Meriwether, the former vice-chairman of bond trading in Salomon Brothers. Board of directors consisted of Myron Scholes and Robert C. Merton, who shared the Nobel Memorial Prize in Economic Sciences. It was a big and famous U.S. hedge fund which specialized in high leverage arbitrage trading strategies such as fixed income arbitrage, statistical arbitrage, pairs trading and etc.
Initially, LTCM obtained enormous success with fee-deducted annual returns of more than 40% in the first year. It is a sound success over the financial industry.
To look into the details of their success, LTCM applied extremely complex mathematical models built by those Nobel Prize winners and university professors and took advantage of fixed income arbitrage deals. Usually the securities were comprised of U.S., Japanese, and European government bonds. For example, unlike the price difference of two company stocks as they could reflect different underlying, the price differences between 30-year Treasury bond and 29-year Treasury bond should be minimal. However, small price discrepancy arose between the two bonds owing to liquidity since on-the-run issue always traded in high volume. By a series of transactions, buying the cheaper 'off-the-run' bond and shorting the more expensive 'on-the-run' bond would be able to undertake a profit as the difference in bond price narrowed once the on-the-run bond getting old.
As LTCM's capital base grew, it became running out of bond-arbitrage bets. LTCM was then determined to undertake more aggressive arbitrage trading strategies. By 1998, LTCM had tremendous amount of positions in those areas such as merger arbitrage and S&P 500 options
LTCM started to gain a lot of profit due to its so-called "risk-free" trading strategies with the fact that the market functioned normally at the early stage. The assumptions behind those complex mathematical models still were acceptably valid.
Because of minor differences in value, the hedge fund needed to undertake highly-leveraged positions to gain significant profits. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of about 25 to 1. The notional value of off-balance sheet derivative was approximately equal to $1.25 trillion.
Coming in the wake of the 1997 East Asian financial crisis, the assumption of market efficiency melted quickly. LTCM incurred lost in May and June in 1998 where the returns were -6.42% and -10.14% respectively. The capital of LTCM has been reduced by $461 million. The problems were exaggerated by the exit of Salomon Brothers from the arbitrage business in July 1998. After that, the Russian Government defaulted on their government bonds. Investors are so panicked that they immediately sold Japanese and European bonds and then buy U.S. treasury bonds. LTCM incurred huge losses because they failed to take profits that were supposed to be generated as the value of these bonds converged (the value of the bonds diverged instead). By the end of August, the fund had lost $1.85 billion in capital.
As a result of high leverage and huge losses, LTCM had to liquidate its positions to cover the expense at the highly unfavorable moment and suffered from even greater losses. A good illustration of the consequences of forced liquidations was given by Lowenstein. He reported that an arbitrage position of LTCM in a dual-listed company called Royal Dutch Shell, when Royal Dutch was trading at an around 10% premium relative to Shell. LTCM essentially gambled in the stock prices of Royal Dutch and Shell to converge. This may be possible in the long run. However, owing to its losses in other positions, LTCM required to unwind the position when the premium had increased to about 22% (LTCM incurred a large loss on this arbitrage trading strategy). LTCM lost $286 million in equity pairs trading.
Due to all market failure and liquidity constraints, LTCM had incurred tremendous amount of losses and were required to shutdown. One may claim that their arbitrage trading strategies may be valid in the long run. But no one can make sure the position can be held for a long time. The huge losses also brought enormous shock to Wall Street due to its large market capitalization. Federal Reserve Bank also needed to carry out a bail-out program to ease the issue.
The misunderstanding about financial market and failure to recognize the change of market condition which made the model assumptions to be invalid brought LTCM, together with the generally accepted genius, a lesson.
