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When Genius Failed

The Rise and Fall of Long-Term Capital Management

By Roger Lowenstein
15-minute read
Audio available
When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein

When Genius Failed (2001) follows the rise and fall of Long-Term Capital Management, the world’s largest ever investment fund. The book reveals uncomfortable truths about the nature of investment and the fragility of the models we use to assess risk.

  • Anyone interested or working in investment banking
  • Anyone interested in risk calculation
  • Anyone thinking about investing in a hedge fund

Roger Lowenstein is an American financial journalist and contributor to the Wall Street Journal. In addition to his many articles and book reviews, he has also written five best-selling books, including The End of Wall Street and While America Aged.

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When Genius Failed

The Rise and Fall of Long-Term Capital Management

By Roger Lowenstein
  • Read in 15 minutes
  • Audio & text available
  • Contains 9 key ideas
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When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein
Synopsis

When Genius Failed (2001) follows the rise and fall of Long-Term Capital Management, the world’s largest ever investment fund. The book reveals uncomfortable truths about the nature of investment and the fragility of the models we use to assess risk.

Key idea 1 of 9

Long-Term Capital Management was an enormous hedge fund that made its money through arbitrage.

It’s a fair bet that you’ve probably never heard of Long-Term Capital Management (LTCM), a long defunct fund management company. The 1997 Asian financial crisis or the 1998 Russian default, however, are two events that are probably much more familiar to you, as they brought the financial world to the brink of collapse. LTCM had an important role to play in both.

LTCM was a hedge fund founded in 1994 by trader John Meriwether. Hedge funds manage the pooled investments of small groups of mostly wealthy investors. Unlike their cousins, mutual funds, which manage the investments of a larger, more economically diverse group of investors, hedge funds are subject to very little regulation, meaning that there are virtually no limits to the size of the fund or where it can be invested.

This lack of regulation makes hedge funds a ripe environment for investment in riskier financial products, such as derivatives.

Like all other hedge funds, LTCM managed their investments with a strategy called arbitrage, whereby hedge fund managers purchase or sell financial products in the hope or knowledge that their price will change in their favor in the near future.

To demonstrate this, imagine that one company sells different stock in two markets. As both stocks represent the same company, you’d expect them to be the same price. However, sometimes the price of the stock in one market may dip below the other. When this occurs, you have an opportunity to quickly buy this stock before the prices reach equilibrium again, after which you can sell that stock at a profit.

In reality, the dynamics of the market don’t create these clear-cut scenarios. In fact, most arbitrage strategies rely on tiny, rapidly disappearing discrepancies in the price of financial products.

This gave LTCM an advantage. They used academic calculations and predictions as well as the latest computer software to recognize the opportunities and exploit them quickly. Using this strategy, LTCM became the largest hedge fund ever. So what happened?

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