Risk Latte - Central Bank of Volatility

Central Bank of Volatility

Rahul Bhattacharya
Mar 01, 2005

Early in 1998 Long Term Capital Management began to short (sell) volatility in the US and European equity markets. This was, in fact its signature trade, one that would ultimately lead to disaster. And true to its name it was selling not only short term volatility but also long term volatility, i.e. selling options that were long dated (more than 2 years). They were mostly selling these long dated volatilities to big banks on Wall Street like J P Morgan, Bankers Trust, Morgan Stanley, etc. LTCM was betting the then levels of implied volatilities in the equity markets (S & P 500, etc.) of 19%-20% were unreasonable and would soon come down.

So much so that by the middle of 1998 LTCM had a staggering $40 million riding on each percentage point change in equity volatility in the U.S. and an equivalent amount in Europe - almost a fourth of the overall market. Morgan Stanley coined a nickname for LTCM as Central Bank of Volatility.

We believe that the above fact is amusing given the current ultra-low volatility regime in the global equities markets.

(For more see Roger Lowenstein's excellent book When Genius Failed.).

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