Nine months before LTCM failed 1997, Merton and Scholes shared the Nobel prize in economics. Merton and Scholes jumped at the chance to join LTCM where they could not only apply their theoretical work but make a great deal of money. LTCM used this credit to leverage their capital base by a factor of twenty to thirty times. In the first few years this allowed LCTM to make spectacular profits for themselves and their investors. Many of the strategies that LTCM used involved derivatives.
Derivatives are more innocent than their sinister reputation.
A derivative is a security that derives its value from an underlying asset. A futures contract for corn, for example, derives its value from the underlying market price for corn. A stock option derives its value from the underlying price of a stock or stock index. Derivatives and the strategies traders use to make money on them can be complex and Lowenstein may have felt that these details would make the eyes of many readers glaze over. As we will see below, LTCM lost most its money on swaps and volatility bets, so these derivatives play an important part in the story.