The Story of Long-Term Capital Management

No doubt this is due to the secrecy of the hedge fund, which never revealed information about its positions, even to its own investors. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July The losses in the major investment categories were ordered by magnitude: It was also necessary to access the financing market in order to borrow the securities that they had sold short. The losses in the major investment categories were ordered by magnitude: One core trade in the LTCM strategies was to purchase the old benchmark — now a

Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm based in Greenwich, Connecticut that used absolute-return trading strategies combined with high financial leverage.

More info on Long Term Capital Management

In the case of LTCM, however, the fund was able to obtain next-to-zero haircuts, as it was widely viewed as "safe" by its lenders. This must have been due to the fact that no counterparty had a complete picture of the extent of LTCM's operations. The core strategy of LTCM can be described as "convergence-arbitrage" trades, trying to take advantage of small differences in prices among near-identical bonds.

Short-term, the position will be even more profitable if the yield spread narrows further. The key is that eventually the two bonds must converge to the same value. Most of the time, this will happen - barring default or market disruption. The fund placed large bets on convergence of European interest rates within the European Monetary System that paid off handsomely. By , however, convergence had occurred in Europe, as the common currency, the Euro, came into being on January Credit spreads were almost as narrow as they had ever been since and considerably lower than the average over the period Convergence trades had generally become less profitable.

This performance, unfortunately, was trounced by U. This was embarrassing, as LTCM touted itself as having the same risk as equities. If it had lower returns, why would anybody invest in the fund?

LTCM had to look for other opportunities. Unfortunately, this also increased the risks. Troubles began in May and June of Then came August Russia announced that it was "restructuring" its bond payments - de facto defaulting on its debt. This bombshell led to a reassessment of credit and sovereign risks across all financial markets. Credit spreads jumped up sharply. The resulting leverage ratio had increased from 27 to to LTCM badly needed new capital.

In his September 2 letter to investors, Meriwether revealed the extent of the losses and wrote that "Since it is prudent to raise additional capital, the Fund is offering you the opportunity to invest on special terms related to LTCM fees. After the bailout, Long-Term Capital Management continued operations. By early , the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back; but the collapse was devastating for many involved.

Mullins, once considered a possible successor to Alan Greenspan , saw his future with the Reserve dashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited.

Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. The Full Wiki Search: Related topics derivative security Hedge fund Arbitrage Modern portfolio theory Short selling List of finance topics. Long Term Capital Management: Many of our articles have direct quotes from sources you can cite, within the Wikipedia article!

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Leading scholar in finance; Ph. Author of Black-Scholes model; Ph. Vice chairman of the Federal Reserve ; Ph. Arbitrage group at Salomon; Ph. Merton added a veneer of genius to the roster at LTCM. Fixed income securities pay a set of coupons at specified dates in the future, and make a defined redemption payment at maturity. Since bonds of similar maturities and the same credit quality are close substitutes for investors, there tends to be a close relationship between their prices and yields.

Whereas it is possible to construct a single set of valuation curves for derivative instruments based on LIBOR-type fixings, it is not possible to do so for government bond securities because every bond has slightly different characteristics.

It is therefore necessary to construct a theoretical model of what the relationships between different but closely related fixed income securities should be.

For example, the most recently issued treasury bond in the US — known as the benchmark — will be more liquid than bonds of similar but slightly shorter maturity that were issued previously. Trading is concentrated in the benchmark bond, and transaction costs are lower for buying or selling it.

As a consequence, it tends to trade more expensively than less liquid older bonds, but this expensiveness or richness tends to have a limited duration, because after a certain time there will be a new benchmark, and trading will shift to this security newly issued by the Treasury.

One core trade in the LTCM strategies was to purchase the old benchmark — now a Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued. If the coupons of the two bonds were similar, then this trade would create an exposure to changes in the shape of the yield curve: It would therefore tend to create losses by making the year bond that LTCM was short more expensive and the This exposure to the shape of the yield curve could be managed at a portfolio level, and hedged out by entering a smaller steepener in other similar securities.

Because the magnitude of discrepancies in valuations in this kind of trade is small for the benchmark Treasury convergence trade, typically a few basis points , in order to earn significant returns for investors, LTCM used leverage to create a portfolio that was a significant multiple varying over time depending on their portfolio composition of investors' equity in the fund.

It was also necessary to access the financing market in order to borrow the securities that they had sold short. In order to maintain their portfolio, LTCM was therefore dependent on the willingness of its counterparties in the government bond repo market to continue to finance their portfolio. If the company was unable to extend its financing agreements, then it would be forced to sell the securities it owned and to buy back the securities it was short at market prices, regardless of whether these were favourable from a valuation perspective.

The fund also invested in other derivatives such as equity options. Under prevailing US tax laws, there was a different treatment of long-term capital gains, which were taxed at The earnings for partners in a hedge fund was taxed at the higher rate applying to income, and LTCM applied its financial engineering expertise to legally transform income into capital gains.

It did so by engaging in a transaction with UBS Union Bank of Switzerland that would defer foreign interest income for seven years, thereby being able to earn the more favourable capital gains treatment. This transaction was completed in three tranches: Put-call parity means that being short a call and long the same amount of notional as underlying the call is equivalent to being short a put.

LTCM faced challenges in deploying capital as their capital base grew due to initially strong returns, and as the magnitude of anomalies in market pricing diminished over time. James Surowiecki concludes that LTCM grew such a large portion of such illiquid markets that there was no diversity in buyers in them, or no buyers at all, so the wisdom of the market did not function and it was impossible to determine a price for its assets such as Danish bonds in September It also broadened its strategies to include new approaches in markets outside of fixed income: Although periods of distress have often created tremendous opportunities for relative value strategies, this did not prove to be the case on this occasion, and the seeds of LTCM's demise were sown before the Russian default of 17 August Since position sizes had not been reduced, the net effect was to raise the leverage of the fund.

Although this crisis had originated in Asia, its effects were not confined to that region. The rise in risk aversion had raised concerns amongst investors regarding all markets heavily dependent on international capital flows, and this shaped asset pricing in markets outside Asia too. In May and June returns from the fund were This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July Because the Salomon arbitrage group where many of LTCM's strategies had first been incubated had been a significant player in the kinds of strategies also pursued by LTCM, the liquidation of the Salomon portfolio and its announcement itself had the effect of depressing the prices of the securities owned by LTCM and bidding up the prices of the securities LTCM was short.

One LTCM partner commented that because there was a clear temporary reason to explain the widening of arbitrage spreads, at the time it gave them more conviction that these trades would eventually return to fair value as they did, but not without widening much further first. Such losses were accentuated through the Russian financial crisis in August and September , when the Russian government defaulted on its domestic local currency bonds.

BREAKING DOWN 'Long-Term Capital Management (LTCM)'

Long-Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize-winning economists and renowned Wall Street traders that nearly collapsed the global financial system in This was due to LTCM’s high-risk arbitrage trading strategies. Long term capital management trading strategies. Back in the mid s, Long-Term Capital Management (LTCM) was one of the largest hedge funds with over $ billion . Of course, the term "hedge" is somewhat of a misnomer, if not misleading, since these investment vehicles are leveraged and can be quite risky. Initially, the new venture was eminently profitable. Capital grew from $1 billion to more than $7 billion by