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Know what went wrong in the LTCM case

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  • Hired many key players, one of earliest to embrace quantitative finance.“My trade is when I hired you” Paid extraordinarily wellMythology based on stock market 1987 crash
  • 40%pa in 1995 n 1996-17% pa in 1997
  • LTCM

    1. 1. The Classis Case of “LTCM” #Post Graduate Program in Securities Markets(PGPSM) @National Institute of Securities Markets(NISM) Vashi, Navi Mumbai
    2. 2. In the long run… John Meriwether
    3. 3. Mythology Stock market crash 1987 Traditional trade or Quantitative and research- driven trade
    4. 4. Modus operandi • The presence of Merton, Scholes and Mullins • $4000 million • 2% management fee and 25% incentive fee
    5. 5. Secret trader’s business• The buzz words were ‘relative value’ and ‘convergence’ trading• Small pricing discrepancies between securities• Long run equilibrium values• Leverage up to 25 times• Myron Scholes explained “Think of us(LTCM) as a gigantic vacuum cleaner sucking up nickels from all over the word”
    6. 6. Let the good times roll Extending to credit spread trading, volatility trading etc.43%pa in 1995 and 41% in 1996
    7. 7. The perfect Storm • By September, LTCM had lost 92% of its capital • Leverage had increased to over 100 times
    8. 8. Origins• The 1998 crisis had its origins in the Asian monetary crisis• LTCM perceived the increase in volatility levels and credit spread as a trading opportunity• Placed a massive bet on credit spread and stock volatility
    9. 9. Credit spread• LTCM believed that, although yield difference between risky and riskless fixed-income instruments varied over time, the risk premium tended to revert to average historical levels.• Entered into mortgage spreads and international high-yield bond spreads
    10. 10. Equity volatility• Assumed that volatility on equity options tended to revert to long-term average levels• LTCM “sold volatility” until it regressed to normal levels
    11. 11. Crisis development• In May/June 1998, a big loss in mortgage backed securities.• In August, Russia defaulted on its debt• Credit spread increased- Large losses on credit spread positions• $550 million on 21 August alone• On 2 September 1998, John Meiwether issued a letter to investors that revealed LTCM had lost 52% of its value.
    12. 12. Recapitalization• On 18 Sep 1998, Bear Stearns was rumoured to have frozen the fund’s cash account following a large margin call• On 23 Sep 1998, AIG, Goldman Sachs, Warren Buffett made an offer to buyout LTCM• 14 banks invested $3.6 billion in return for 90% of LTCM
    13. 13. Weather forecast• At beginning of 1998, LTCM VaR was $45 million at 99% confidence level• In Sep, LTCM’s profit and loss was moving $100-$200 million daily• LTCM’s models assumed that it would be possible to reduce positions across the entire portfolio rapidly, but not all position were liquid
    14. 14. Copy Cats • Many dealers established internal hedge fund • When storm hit, everybody had put on same trades
    15. 15. Hubris
    16. 16. Endgame• John Meriwether established a new hedge fund (JWM Associates)• Scholes set up a separate hedge fund• Scholes promoted a new product – liquidity options