Cases in Tail Events Flashcards
Practice questions
- Were the losses to investors of Amaranth Fund to be expected given the high risks of the fund’s investment strategy?
• No, Amaranth was a multistrategy fund with a stated strategy that would not lead investors to expect such losses. For example, external investors would not expect that 50% of its capital was dedicated to one specific market/trade. Amaranth had very large, highly levered and concentrated positions but apparently had no formal stop-loss or concentration limits. This suggests that Amaranth’s internal people likely severely underestimated the probability of long-term and large unidirectional price movements against its positions.
- What was the primary premise of Long Term Capital Management’s trading strategies?
• The primary premise of Long Term Capital Management’s trading strategies was the expectation that the spread in prices or rates between two similar securities would converge over time. LTCM would buy the cheaper security and short the more expensive security (while applying tremendous leverage) and wait for the spread between the two similar securities to narrow before closing
the trades.
3.How could Carlyle Capital Corporation suffer large losses from a strategy dominated by long positions in AAA-rated securities?
• Carlyle Capital Corporation used significant leverage in order to initiate its long positions in AAA-rated securities. When the creditworthiness of AAA-rated mortgage securities came under question, the value of the AAA-rated mortgage securities decreased and Carlyle Capital Corporation received margin calls from its creditors that it could not fulfil. It is alleged that the AAA-ratings were undeserved.
- How is behavioral finance related to fund failures?
• Behavioral finance attempts to explain the potential influence of cognitive, emotional, and social factors in opposition to evidence and reason. For example, these factors can lead fund managers to take enormous risks to try to offset losses in the face of evidence that a strategy is not working. These biases can also lead investors with overconfidence to select managers that are more likely to commit fraud because the managers are playing to the emotions of the investors.
- What is believed to be the cause of the Flash Crash in 2010?
• Initially the SEC reported that a “backdrop of unusually high volatility and thinning liquidity” just as “a large fundamental trader (a mutual fund complex) initiated a program to sell a total of 75,000 E-Mini S&P contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.” Subsequently, it has been alleged that the flash crash was caused by spoofing – the placing of intentionally deceptive offers designed to move markets by a trader (or group of traders) holding massive positions that hope to benefit from the market moves.
- What pattern of trading orders is believed to have caused Knight Capital Group’s demise?
• According to an analysis by Nanex, a Knight algorithm appeared to have been repeatedly buying at the offer and selling at the bid, causing Knight to lose a small amount of money (the spread) on each trade – losing huge sums due to the trades being repeated over and over again.
- What primary issue could a prospective investor have researched in order to avoid losses from investing in Bayou Fund?
• A prospective investor could have researched the background of the principals of the fund, which would have uncovered evidence of dishonesty. In addition, the prospective investor could have researched the auditing firm and found that Richmond-Fairfield had only one employee, a Bayou employee, and only one client, Bayou.
- Why should an investor who exits a fraudulent scheme before it collapses be concerned about the losses of the investors who did not exit prior to the collapse?
• Courts can order investors who are enriched by a fraud to return the profits as restitution to those who suffered losses, even if the investors were unaware of the investment’s fraudulent nature.
- Why were the closing market prices of Lancer’s positions argued to be unreliable?
•It is alleged that Lauer manipulated the market price of thinly traded shares by placing trades at key points in time to print (“paint”) high prices in the stock’s trading record and thereby justifying placing high values on the fund’s holdings. Not only were the public shares not regularly trading at these prices but also the restricted shares held by Lancer were likely to be worth even less than the registered shares.
- List four major lessons from the chapter’s cases in tail events.
- A consistent theme across many of the cases is the danger of using large amounts of leverage.
- Over-confidence of traders can lead to high risk and high losses.
- Highly-quantitative financial systems using high-tech capabilities may contain risks that are difficult to predict, and
- The large fees and assets of the hedge fund world attract both geniuses and charlatans.
