Inventing Money | Nicholas Dunbar

Summary of: Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It
By: Nicholas Dunbar


Dive into the riveting story of Long-Term Capital Management (LTCM), an investment company founded by John Meriwether, Myron Scholes, and Robert Merton, which soared to financial prominence and then collapsed, sending shockwaves through international markets. In Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It, Nicholas Dunbar traces the development of complex financial models and tools, the revolutionary impact of financial engineering on markets, and how the company’s risky trading strategies and leverage led to its stunning demise. Learn about the profound influence of the Black-Scholes-Merton theories, the competitive nature of arbitrage, the appearance and consequences of various financial instruments, and how the forces of human behavior and market volatility ultimately shattered LTCM’s empire.

Rise and Fall of Long-Term Capital Management

Long-Term Capital Management (LTCM) was a hedge fund formed by John Meriwether, Myron Scholes, Robert Merton, and a team of traders. Using mathematical and computerized models, the fund generated fantastic profits from 1995 to 1997. It rewarded investors with $2.7 billion in excess capital and increased its portfolio to $130 billion in assets. However, in 1998, LTCM started to collapse, losing 90% of its value, and the effects were felt worldwide. The fund’s failures can be attributed to the collapse of its mathematical models based on certain assumptions about trading prices. Private bankers and government regulators organized a bailout to avoid a potential global market collapse. This event was the pinnacle of a 30-year-long revolution in finance, which had done for trading and investment what the Apollo space program had done for lunar exploration. The failure of LTCM was a harsh reminder that even the most advanced financial models could fail without proper attention to potential risks.

The Origins of Financial Engineering

This book delves into the historical roots of financial engineering and options trading, tracing the concepts back to the first uses of money in the Middle East thousands of years ago. The use of statistics and mathematics in understanding markets became popular in the U.S. after Adam Smith developed his theory of markets in 1776. The book also explores the key statistical measures that would become influential, including the normal distribution curve and the Brownian motion theory. The story of Long Term Capital Management, which was founded on the rational theory of option pricing, is intertwined with the greed and risk factors that drive options trading. The book explains how the fear and greed sides of options justify their existence and their price.

Financial Engineering: The Origins and Evolution of Modern Investing

This book takes us on a journey through the evolution of modern investing. From the development of portfolio theory by Harry Markowitz to the Black-Scholes formula, we learn about the transformative impact of financial engineering on the trillion-dollar financial system we know today. Although the measures Markowitz and Sharpe proposed were not well recognized in the 1950s and 1960s, financial economics was emerging, and traditional approaches, such as researching companies’ performance, were still predominant. In 1969, Black and Scholes constructed the Black-Scholes option pricing formula based on the CAPM model. This technique provides a greater level of precision in pricing an option fairly and supports traders in efficiently balancing their holdings to protect against market volatility. Fischer Black, Myron Scholes, and Robert Merton invented Financial Engineering. It started with warrants, but it quickly expanded to different trades due to the success they had witnessed. Financial engineering, with the help of modern-day mathematics, has now become an essential and INEVITABLE aspect of modern investing.

The Birth of Bond Arbitrage

The story of John Meriwether, former Salomon Brothers bond trader, who transformed bond arbitrage into a business, is a fascinating example of financial innovation. Meriwether’s early years at Salomon coincided with in-depth research into bonds’ different periods of maturity by Marty Liebowitz, head of bond research. Traders could track the yield curve, predicting the eventual yield and judging the movement as the shape of the curve changed due to bond prices. Meriwether began betting on how the curve would react and soon led a team of New York traders buying and selling Treasury bonds, while he also led a team of pit brokers in Chicago who sold equivalent T-bond futures. He hedged bond prices with futures to reduce any losses. As the size of his trades increased, so did his profits. Today, bond arbitrage is a popular strategy for investors, and the story of how it came to be is a compelling tale of innovation and risk-taking that changed the face of Wall Street.

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