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  1. 1. Long Term Capital Management
  2. 2. Summary of Events • In 1994, John Meriwether, the famed Salomon Brothers bond trader, founded a hedge fund called Long-Term Capital Management.
  3. 3. • Meriwether assembled an all-star team of traders and academics in an attempt to create a fund that would profit from the combination of the academics' quantitative models and the traders' market judgement and execution capabilities.
  4. 4. • Sophisticated investors, including many large investment banks, flocked to the fund, investing $1.3 billion at inception.
  5. 5. • But four years later, at the end of September 1998, the fund had lost substantial amounts of the investors' equity capital and was teetering on the brink of default.
  6. 6. • To avoid the threat of a systemic crisis in the world financial system, the Federal Reserve orchestrated a $3.5 billion rescue package from leading U.S. investment and commercial banks. • In exchange the participants received 90% of LTCM's equity.
  7. 7. What was LTCM’s Strategy • The basic principle of LTCM’s strategy was that in the long term, the price of a security would converge to its fair market value even though there may be mispricing in the short term.
  8. 8. • LTCM utilized computer models to find arbitrage opportunities between markets. LTCM's central strategy was convergence trades where securities were incorrectly priced relative to one another. LTCM would take long positions on the under priced security and short positions on the overpriced security.
  9. 9. • The strategy depended on exploiting deviations in market value from fair value. And it depended on "patient capital" -- shareholders and lenders who believed that what mattered was fair value and not market value. That is, because the fair values were hedged, it didn't matter what happened to market values in the short run — they would converge to fair value over time. That was the reason for the "Long Term" part of LTCM's name.
  10. 10. • A convergence trading strategy in the stock markets, is a trade idea based on the principle that when the price of a stock (or stock portfolio) significantly deviates from its long- term trend, it will sooner or later converge (move back) back to its original trend. For example, a trading strategy that generates a buy signal at every dip of the stock price in a general up trend is a convergence trading strategy.
  11. 11. Convergence trades • LTCM's main strategy was to make convergence trades. These trades involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones.
  12. 12. There were four main types of trade: • Convergence among U.S., Japan, and European sovereign bonds; • Convergence among European sovereign bonds; • Convergence between on-the-run and off- the-run U.S. government bonds; • Long positions in emerging markets sovereigns, hedged back to dollars.
  13. 13. • Because these differences in values were tiny, the fund needed to take large and highly- leveraged positions in order to make a significant profit. At the beginning of 1998, the fund had equity of $5 billion and had borrowed over $125 billion — a leverage factor of roughly thirty to one.
  14. 14. • LTCM's partners believed, on the basis of their complex computer models, that the long and short positions were highly correlated and so the net risk was small.
  15. 15. What Does On-The-Run Treasuries Mean? • The most recently issued U.S. Treasury bond or note of a particular maturity. These are the opposite of "off-the-run treasuries".
  16. 16. What Does Sovereign Bond Mean? • A debt security issued by a national government within a given country and denominated in a foreign currency.
  17. 17. LTCM ‘s positions • LTCM had fixed income and equity positions. The equity positions were a mix of index spread trades, total return swaps and some takeover positions.
  18. 18. Total return swap • In a total return swap, the party receiving the total return will receive any income generated by the asset as well as benefit if the price of the asset appreciates over the life of the swap. • In return, the total return receiver must pay the owner of the asset the set rate over the life of the swap. • If the price of the assets falls over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price.
  19. 19. Example • For example, two parties may enter into a one-year total return swap where Party A receives LIBOR + fixed margin (2%) and Party B receives the total return of the S&P 500 on a principal amount of $1 million. If LIBOR is 3.5% and the S&P 500 appreciates by 15%, Party A will pay Party B 15% and will receive 5.5%. The payment will be netted at the end of the swap with Party B receiving a payment of $95,000 ($1 million x 15% - 5.5%).
  20. 20. What is a Takeover • In business, a takeover is the purchase of one company (the target) by another (the acquirer, or bidder).
  21. 21. The Ultimate Cause of the debacle
  22. 22. Flight to Liquidity • The ultimate cause of the LTCM debacle was the "flight to liquidity" across the global fixed income markets. • As Russia's troubles became deeper and deeper, fixed-income portfolio managers began to shift their assets to more liquid assets.
  23. 23. • What LTCM had failed to account for is that a substantial portion of its balance sheet was exposed to a general change in the "price" of liquidity. If liquidity became more valuable (as it did following the crisis) its short positions (rich assets) would increase in price relative to its long positions (cheap assets). • This was essentially a massive, unhedged exposure to a single risk factor.
  24. 24. • Capital is only as patient as its least patient provider. The fact is that lenders generally lose their patience precisely when the funds need them to keep it — in times of market crisis. • As the case demonstrates, the lenders are the first to get nervous when an external shock hits.
  25. 25. • At that point, they begin to ask the fund manager for market valuations, not models-based fair valuations. • This starts the fund along the downward spiral: illiquid securities are marked-to-market; margin calls are made; the illiquid securities must be sold; more margin calls are made, and so on. • In general, shareholders may provide patient capital; but debt-holders do not.
  26. 26. • The only real source of capital that is patient enough to take fluctuations in market values, especially through crises, is equity capital. In other words, you can take liquidity bets, but you cannot leverage them much.
  27. 27. Lessons
  28. 28. The lessons to be learned from this crisis are • Market values matter for leveraged portfolios; • Liquidity itself is a risk factor; • Models must be stress-tested and combined with judgement;
  29. 29. • LTCM fell victim to a flight to liquidity. This phenomenon is common enough in capital markets crises that it should be built into risk models, either by introducing a new risk factor — liquidity — or by including a flight to liquidity in the stress testing.
  30. 30. • Another key lesson to be learnt from the LTCM debacle is that even (or especially) the most sophisticated financial models are subject to model risk and parameter risk, and should therefore be stress-tested and tempered with judgement.
  31. 31. • According to the complex mathematical models used by LTCM, the positions were low risk. Judgement tells us that the key assumption that the models depended on was the high correlation between the long and short positions.
  32. 32. • Certainly, recent history suggested that correlations between corporate bonds of different credit quality would move together (a correlation of between 90-95% over a 2-year horizon). • During LTCM's crisis, however, this correlation dropped to 80%. • Stress-testing against this lower correlation might have led LTCM to assume less leverage in taking this bet.
  33. 33. The End