In September of 1998 a company called Long-Term Capital Management (LTCM) lost $100 billion mis-managing the concept of arbitrage. LTCM had attempted to make money on the difference between different fond instruments. For example, it would buy U.S. treasury bonds and sell Italian bond futures. The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge. Because the difference was small, large amount of money had to be borrowed to make the buying and selling profitable.
The downfall is this system culminated on August 17, 1998, when Russia defaulted on its ruble debt and domestic dollar debt. Since the markets were already nervous due to the Asian crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment. As a result the return on U.S. treasuries began decreasing because there were many buyers, and the return on other bonds began to increase because there were many sellers. This caused the difference between the returns of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and a government bailout had to be arrange to prevent a collapse in confidence in the economic system generated by panic selling in the bond markets.
To be continued...