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The Equitymaster Research Digest

When Investors Expect To Get Paid For Activity...
Sep 13, 2016

  • The lure of a billion-dollar IPO
  • Cues of Sensex 40,000 this earning season
  • BHEL's 15% rise and Yes Bank's 15% fall

Let's start the Digest today with the story of DE Shaw & Co.

Founded in 1988, Shaw was staffed by some of the brightest mathematicians, computer scientists, and bond trading experts on the planet. Jeff Bezos worked at Shaw before embarking on his Amazon.com journey. The firm had figured out that there was a lot of money to be made from risk-free arbitrage in the bond markets. Especially with some highly sophisticated bond arbitrage trading algorithms.

And so with highly leveraged capital, Shaw was able to capitalise on minuscule short-term inefficiencies in the bond markets. The annualised returns were nothing short of spectacular - and all of it risk-free!

The bright folks at Shaw put their trading on autopilot - only minimal human tweaking required. As per reports, they came to work and mostly played pool or video games. Shaw's profit per employee was astronomical. And for a while everyone was happy with this utopian arrangement.

But eventually, the nerds got fidgety - they wanted to do something. They felt they had only scratched the surface. If they only dug deeper, there would be more gold to be mined. And so they fiddled with the system to try to juice returns.

What followed was a fate similar to that of Long-Term Capital Management (LTCM). LTCM was a Wall Street fund once considered so big and so smart that it simply could not fail. And yet, when economic events that did not conform to its historical model took place in rapid succession, it nearly did just that. The firm gradually moved from pure risk-free arbitrage to playing the risky arbitrage game in the equity markets. A lot more capital could be deployed, and the returns looked appealing. But when disaster struck, with highly leveraged positions, the fallout nearly destroyed them.

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