LTCM treated volatility as risk. LTCM relied heavily on these elegant models
to compute risks. Using models to calculate risk only provide a greater sense
of security than warranted. The real world is uncertain. Dice is predictable
while Russia is not. Some things cannot be simply plug be into a mathematical
model. Uncertainty is an abstract concept, one that does not conform to
arithmetic. The belief that future risk can be calculated from yesterday prices
or past volatility is asinine. Not all that matters can be calculated, while
not all that can be calculated matters.
You could be highly leveraged but liquid, or you could be
liquid with moderate leverage. LTCM was
highly leveraged yet their trades were illiquid. This not only requires them to
be correct merely at the end but it requires them to be correct every single
day until the day of maturity. That is akin to playing Russian roulette.
Although eventually their trades do converge, they didn't manage to keep their
head above water till then. Like how John Maynard Keynes put it, the market
could stay irrational longer then you could stay solvent.
They ventured out of bond arbitrage which was their
circle of competence, into other unfamiliar areas such as equity volatility.
After a winning streak, hubris sets in. LTCM partners
felt like they could do no wrong.
One thing that completely baffled me was that LTCM
partners were willing to leverage up and bet heavily for dollars they want but
don't need(They were already super rich), in the meantime risking everything
they need.
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