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What We Learned from Incident of Ltcm

Autor:   •  November 29, 2015  •  Essay  •  301 Words (2 Pages)  •  220 Views

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What we learned from incident of LTCM

  • Leverage

The central public policy issue raised by the LTCM episode is how to constrain excessive leverage more effectively. As incident in 1998, the amount of leverage in the financial system, combined with aggressive risk taking, can greatly magnify the negative effects of any event or series of events. By increasing the chance that problems at one financial institution could be transmitted to other institutions, leverage can increase the probability of a general breakdown in the functioning of financial markets.

  • Overall Risk Profile

A further issue concerns the degree to which the management of credit risk in trading relationships should take account of the link between market risk, liquidity risk, and credit risk. The fall-out from recent market shocks shows the need to go beyond value-at-risk and potential future exposure models built only on very recent price data that may underestimate both the size of potential shocks to risk factors and their correlation. It appears that some of the risk models used by LTCM and its creditors and counterparties were flawed.

  • Stress-testing

Stress testing was not thoroughly performed at all firms. While most firms were stress testing their proprietary positions with parallel volatility curve shifts and correlations, aggregate counterparty credit exposures were not always routinely stress tested. Stress testing helps identify those counterparties likely to create the greatest credit exposures in market environments more severe than standard risk measurement methods assume. When positions are relatively large and leveraged, it is important to account for the price impact of forced sales. Because the traditional risk-management models didn’t attention to asset and funding liquidity. We should do more like stress-testing, not just repeating past episodes but instead looking at worst-case scenarios for the portfolio at hand. Wall Street lender also badly need to integrate market and credit risks.

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