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

In the 1998 collapse of Long-Term Capital Management (LTCM), which modeling weakness most directly contributed to the fund's underestimation of its potential losses?

LTCM relied on historical correlations and volatilities that assumed convergence trades would remain diversified. In the 1998 crisis, correlations spiked and spreads widened together, so losses far exceeded model estimates. The failure was in model assumptions and stress scenarios, not an absence of risk measurement.

  1. AReliance on historical correlations and volatilities that assumed spreads would stay stable and diversified across marketsCorrect
  2. BUse of mark-to-market accounting that overstated gains on illiquid positions
  3. CExcessive reliance on unhedged foreign currency exposure to Asian currencies
  4. DFailure to use any statistical measures such as VaR to monitor risk

Explanation

LTCM's models used historical data from calm periods and assumed low correlations across convergence trades. In the 1998 Russian default flight to quality, correlations rose sharply and spreads widened together, so losses far exceeded model estimates. LTCM did use VaR, so the last option is wrong.

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