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

by Roger Lowenstein

At each infinitesimal moment, traders would readjust the price of options on IBM, keeping them in synchrony with the price of the stock. And traders who owned both could—by nimbly buying or selling—keep their portfolio in an Edenic, risk-free state of balance. In short, Merton assumed a perfect, risk-free arbitrage. This assumption may approximate real markets when they are calm—but only then. In 1987, so-called portfolio insurance was marketed (with absurd ballyhoo) to institutional investors as a technique of limiting losses via continuous selling when markets fall. These portfolio insurers helped to exacerbate a market crash that was later dubbed Black Monday. That day, the market was highly discontinuous. Portfolio insurers who had counted on nimbly limiting their losses couldn’t keep pace with the panic that broke out on Wall Street and, indeed, lost their shirts.