I'd recommend reading both if this sort of thing interests you, in the order that they are listed.
Since this article is mostly about LTCM, its kindof interesting to look at their downfall and realize that in the end they were right, their trades ended up being profitable, they were just so leveraged that when the markets started to diverge they couldn't make their margin calls.
Interestingly the reason things went south so fast was that LTCM and the banks had different risk models.
To LTCM they would do spread trades, where you take 2 very similar instruments, the article mentions 29.5 and 30 year bonds. You short the one you think is expensive and buy the one you think is cheap and hold them until the prices converge.
This has a nice risk management feature that the risk on both cancel each other out almost as if the markets move up, your long leg covers the loss on your short leg and visa versa if markets move down.
Unfortunately, partially due to secrecy(trying to hide what they were doing) and partially due to just who had the bond inventory to short from, they often ended up having the long leg and the sort leg at two different banks.
So to LTCM they were perfectly hedged, while to the bank with the short positions, if the market went up they needed LTCM to send them more margin. So LTCM, which was already heavily leveraged was required to send their prime brokers margin that they never figured they'd need to.
Couple that with markets that started move in an unprecedented manner caused too many of their spreads to diverge beyond what they could cover.
The firm ends up getting a margin call it can't afford, liquidates everything to its prime brokers and other investment banks and those banks end up making money off their trades in a time frame from 6 months (for Goldman) to 3 years for the longer term bonds.
Even when your models are right the market can still rip you to shreds:(
EDIT
As to book recommendations below is a picture of my work bookshelf. Id' recommend most of
the books on the shelf:
https://imgur.com/OdzB4aW
http://www.amazon.com/Inventing-Money-Long-Term-Capital-Mana...
Most people read this book but I think the above book is much better.
http://www.amazon.com/When-Genius-Failed-Long-Term-Managemen...
I'd recommend reading both if this sort of thing interests you, in the order that they are listed.
Since this article is mostly about LTCM, its kindof interesting to look at their downfall and realize that in the end they were right, their trades ended up being profitable, they were just so leveraged that when the markets started to diverge they couldn't make their margin calls.
Interestingly the reason things went south so fast was that LTCM and the banks had different risk models.
To LTCM they would do spread trades, where you take 2 very similar instruments, the article mentions 29.5 and 30 year bonds. You short the one you think is expensive and buy the one you think is cheap and hold them until the prices converge.
This has a nice risk management feature that the risk on both cancel each other out almost as if the markets move up, your long leg covers the loss on your short leg and visa versa if markets move down.
Unfortunately, partially due to secrecy(trying to hide what they were doing) and partially due to just who had the bond inventory to short from, they often ended up having the long leg and the sort leg at two different banks.
So to LTCM they were perfectly hedged, while to the bank with the short positions, if the market went up they needed LTCM to send them more margin. So LTCM, which was already heavily leveraged was required to send their prime brokers margin that they never figured they'd need to.
Couple that with markets that started move in an unprecedented manner caused too many of their spreads to diverge beyond what they could cover.
The firm ends up getting a margin call it can't afford, liquidates everything to its prime brokers and other investment banks and those banks end up making money off their trades in a time frame from 6 months (for Goldman) to 3 years for the longer term bonds.
Even when your models are right the market can still rip you to shreds:(
EDIT As to book recommendations below is a picture of my work bookshelf. Id' recommend most of the books on the shelf: https://imgur.com/OdzB4aW
https://imgur.com/zdLSEek