In 1994, LTCM earned 28 percent which is a lot due to the fact that the average bond investor had lost money. J.M. would write a letter to his investors on the possibility and odds of losses in the future and for investors to not expect a repeat. Merton and Scholes used their advanced math knowledge to devise precise mathematical odds of when and how much they could possibly lose.
LTCM tried to quantify every aspect of trading, associating past volatility with their assessment of future risks. They were basically conducting an experiment in managing risk by numbers. LTCM trades were an attempt at exploiting spreads that reflected what they seemed to be inaccurate future volatility risk. Black-Scholes made an assumption that the volatility of a security is constant. Merton took that assumption a step further and assume that prices would trade without any jumps. Merton found that a trader who owned both the price of an option and the price of the stock could operate in a perfect, risk-free arbitrage. This would become an essential building block in LT’s hedging strategies.
There were multiple people who either studied under or with Black, Scholes, and Merton that found inaccuracies in their assumptions, such as Eugene Fama. He discovered that there were many more days of extreme price movements than would occur in a normal distribution. The tail ends of the distribution differed from that of Merton’s because due to the fact he thought of them to be swollen. Such an example was Black Monday.
Over the first two years, LTCM had only one month which they lost more than 1 percent. Their equity capital had almost tripled to a total of $3.6 billion in that time.
Why do financial markets run to extremes more often than say, a coin flip? How would this impact the market and investors?