When Genius Failed: The Rise and Fall of Long-Term Capital Management

by Roger Lowenstein

And Long-Term would have to settle up—paying or receiving monies according to how option prices moved—every day. It might be right on equity vol in the long run, but only if it could stand the pain in the short run. And over five years, the pain suffered on such a large trade could be considerable. On a given day, it was possible that no one would want to sell, in which case Morgan could mark up the asset to whatever higher price it decided was reasonable. Therefore, Long-Term wasn’t betting only on the extent of ultimate realized volatility, it was betting on day-by-day inferred volatility, as determined by what other investors would pay for options. In effect, it was betting that these other, and presumably less rational, investors wouldn’t bid up prices further. This was—so unlike the partners’ credo—rank speculation. By putting themselves at the mercy of short-term fluctuations, the partners had abandoned whatever advantage lay in their precise mathematical models.