RE: Rockat Scientists with Fat Tails
LTCM got its fat tails stomped in the flight to quality. Scholes and Merton are not, strictly speaking, "rocket scientists" because they are trained and practice as financial economists. Rocket scientists are mathematicians and physicists who have fled to Wall Street to get rich, and often have. The article makes a good point in describing the way spreads and swaps multiply the effectiveness and riskiness of limited capital. Just as a bank borrows short (from depositors) to lend long (bonds and mortgages) and often gets in time mismatch problems, so an investment house may find itself short US 30-year bonds and long (much higher interest rate) Mexican Brady bonds. With a "flight to quality" the house may have to pay cash and mark to market, to get which, if leveraged enough, it will have to dump the Bradies and buy back some Treasuries. Thus LTCM and its friends can transmute something like the Russian collapse into a world wide sell off. Note that any long-term securities are unrescuable through a general loosening of monetary conditions unless more and more securities are made bankable (as in Japan). Of course, if the widening doesn't work, this liquifaction of assets simply makes things worse (as in Japan). Unless people are completely confident that everything can be turned into cash, the whole system can collapse. If you are not confident of the outcome, it is tempting (verging on mandatory) to sell everything out while prices are down only 10-20 per cent (as some members of this thread have announced). This is known as getting while the getting is good to avoid being trampled in the panic. As we bounce along the bottom. we constantly recalculate the chances of a rapid turnaround. The odds become smaller and smaller, therefore the risk of missing a big move upwards becomes small. What is the chance of Dell taking off when it is already as highly priced as it is? In my opinion, this is not a bad time to replace all shares with cash and an equivalent number of out-of-the-money 2001 LEAPS calls on Dell and Cisco (or if you are really scared -- try a few in the money LEAPS bearish call spreads), and maybe Intel (because they are cheap). This works well if
things keep going well to January 2001, if things turn out badly in the next year and then turn around, and saves a lot of capital for a big party if it turns out to be the end of the world. |
