In 1998, Long Term began to short equity volatility. This idea, referred to as “equity vol”, comes from the Black-Scholes model. This model and the theory behind it assumes the volatility of stocks is consistent over time. This economic model along with many others told firms equity vol was being mispriced, and the firms began to bet against it.
An equity vol isn’t an explicit stock or security, but there is an indirect way to bet on it. Lowenstein describes betting on the volatility of the market as an analogy of betting on the weather in Florida. The price of orange juice fluctuates according to the odds of a frost occurring, so one can infer high orange juice prices may represent the market is expecting a frost and a shortage of oranges. Similarly, Long Term deduced the stock market was expecting volatility at 20% when it was really closer to 15%. Assuming option prices would sooner or later fall, Long Term then began to short options on the S&P 500 index, calling it “selling volatility”. This was considered to be very risky, as volatility is not easily predictable, fluctuates on a daily basis, there is a small market for selling volatility, and international markets too play a role in volatility.
1998 started off well, Long Term’s leverage was up, and even though the partners took out huge personal loans, their exposure seemed to be appropriate. Partners at Long Term weren’t anxious of losing, they were anxious about finding enough investments to win. Long Term began to make more directional bets instead of their landmark hedging strategy. However, partners at Long Term began to lose patience in researching and analyzing trades and there began internal conflict within the partnership; tensions which Wall Street knew nothing about. Banks and other firms soon began to cut back on less liquid bonds, which were the kind of bonds Long Term’s portfolio consisted of. A Salomon trader in London noted that “as people liquidated, volatility moved up. That forced more people to liquidate.”
Soon the US economy as a whole began to slow. Yields on Treasuries fell to 6.7%. Russia’s financial system was on the verge of collapse. The IMF bailout in Indonesia also ran into some difficulties. The Swiss bank was also completely exposed as it was Long Term’s largest investor.
Things continued to look down, as Long Term began losing money in every market it was a part of. The stock market was suddenly very volatile, and option prices jumped. Implied volatility rose to 27%, creating a substantial loss for Long Term as it had shorted equity vol at far lower levels. In June, Long Term experienced its worst month ever, losing 10%.
In April of 1998, the swap spread in the US was 48 basis points. This is the difference between the LIBOR and the Treasury yield. Long Term however, had bet this spread would narrow as Long Term saw no recession on the horizon.
In July, Salomon announced its exit from US arbitrage, declaring “Opportunity for arbitrage profits has lessened over time while the risks and volatility have grown.” Long Term partners underestimated the seriousness of the net largest player in their business quitting.
In August, The US was affected by the crisis in Russia even after its IMF bailout, weakness in Asia, Iraq’s refusal to permit weapon inspections, the possibility of China’s currency devaluing, and presidential tumult. Thirty-year bond yields hit another all-time low, reaching 5.56%, and credit spreads kept widening. Long Term was losing money in August, for the third month of four. Long Term partners were optimistic, thinking the spread would have to eventually narrow. Long Term decided to jump more into Russia, where it already owned both hedged and unhedged bonds. Even though it was against Long Term’s way, it went long into Russia, which was now the spectacle of the entire world.
- What is the relationship noted about liquidation and volatility?
- What did it mean to bet on volatility?
- What was the risk associated with arbitrage?
- How did the strategy and mind set of Long Term change throughout the chapter?
- What did the fall in Treasury yield indicate?