The Finance Professor: Manage Risk Like a Pro

Accept the Risk That You Understand

When it comes to taking risk, you have to accept risk that you understand. For example, as smart as Long-Term Capital Management was, I knew the end was near when the hedge fund started to expand into markets and strategies in which they had little or no experience or knowledge.

I dealt with LTCM from the day it started to operate. At the time, as the head of Global Equity Swaps at Merrill Lynch (MER Quote), I was on the other side of many swap trades with LTCM. LTCM wanted to do a "risk arbitrage " swap on Tellabs' (TLAB Quote) acquisition of Ciena (CIEN Quote). I knew the deal was going to go bust because for all of LTCM's Nobel Prizes and doctorates, it simply had no idea what it was getting into.

To make a long story short, I refused to do the deal and stood my ground, and two weeks later the Tellabs/Ciena merger was canceled. Several weeks later, LTCM went belly up.

I was able to identify that LTCM did not fully understand the risks involved with the contemplated transaction. As a trader responsible for protecting my employer's capital, I was also acting in a risk-management capacity, because I would have been exposed to credit risk if I'd taken the other side of the swap from LTCM. LTCM did not understand the trade, but I did and thus prevented the fund from making a big mistake.