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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

In 1998, Long-Term Capital Management (LTCM) relied on models calibrated to historical data that implied very low probabilities of the loss sizes it later suffered. Which model-risk weakness best describes the main flaw in that approach?

The key flaw was assuming historical correlations and volatilities would persist. In the 1998 liquidity crisis, correlations among LTCM's positions jumped and spreads widened together, so diversification vanished and losses far exceeded what the calibrated models predicted.

  1. AAssuming that historical correlations and volatilities would hold in a market-wide liquidity crisisCorrect
  2. BUsing only unleveraged positions, which understated expected returns
  3. CRelying on daily marking to market, which overstated losses
  4. DExcluding all convergence trades from the risk models

Explanation

LTCM's models used calm-period history and assumed diversification across positions. In the 1998 flight to quality, correlations rose and spreads widened together, so losses far exceeded model estimates. The other options are inconsistent with the facts: LTCM was highly leveraged and its core strategy was convergence trades.

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