Long-Term Capital Management

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Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether (the former vice-chairman and head of bond trading at Salomon Brothers). On its board of directors were Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics[1]. Initially successful, in 1998 it lost $4.6 billion in less than four months. The fund folded in early 2000.

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[edit] Founding members

In addition to Meriwether, Scholes, Chincarrini and Merton, also joining the company as principals were Eric Rosenfeld, Greg Hawkins, Larry Hilibrand, Dick Leahy, Victor Haghani and James McEntee. On 24 February 1994, LTCM began trading with $1,011,060,243 of investor capital.

[edit] Strategy

The company had developed complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. The basic idea was that over time the value of long-dated bonds issued a short time apart would tend to become identical. However the rate at which these bonds approached this price would be different, and that more heavily traded bonds such as US Treasury bonds would approach the long term price more quickly than less heavily traded and less liquid bonds.

Thus by a series of financial transactions (essentially amounting to buying the cheaper 'off-the-run' bond and short selling the more expensive, but more liquid, 'on-the-run' bond) it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond came on the run.

As LTCM's capital base grew the need for additional returns on that expanded capital led it to undertake other trading strategies. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998 LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). In fact some market participants believed that LTCM had been the primary supplier of S&P 500 gamma which had been in demand by US insurance companies selling equity indexed annuities products for the prior two years.[citation needed]

Because these differences in value were minute — especially for the convergence trades — the fund needed to take highly-leveraged positions in order to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off-balance sheet derivative positions amounting to $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

[edit] 1998 downturn

The downfall of the fund started in May and June 1998 when net returns fell 6.42% and 10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998.

The scheme finally unraveled in August and September 1998 when the Russian government defaulted on their government bonds (GKOs). Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August the fund had lost $1.85 billion in capital.

The company, which was providing annual returns of almost 40% up to this point, experienced a Flight-to-Liquidity. This prompted a bail-out of $3.625 bn by the banks, organized by the Federal Reserve Bank of New York, ostensibly in order to avoid a wider collapse in the financial markets. The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices which would force other companies to liquidate their own debt creating a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):

See also: East Asian financial crisis

Long Term Capital was audited by Pricewaterhouse LLP. The lead partner on the engagement was John Reville (Pricewaterhouse LLP - Manhattan office).

[edit] A deeper understanding of the risks taken by LTCM

The profits from LTCM's trading strategies were generally not correlated with each other and thus normally LTCM's highly leveraged portfolio benefited from diversification. However, the general flight to liquidity in the late summer of 1998 led to a marketwide repricing of all risk leading these positions to all move in the same direction. As the correlation of LTCM's positions increased, the diversified aspect of LTCM's portfolio vanished and large losses to its equity value occurred. Thus the primary lesson of 1998 and the collapse of LTCM for Value at Risk (VaR) users is not a liquidity one, but more fundamentally that the underlying Covariance matrix used in VaR analysis is not static but changes over time.

In the end, LTCM's basic idea was correct, in that the values of government bonds did eventually converge, but only after the firm was wiped out. Nonetheless, the incident confirms an insight often (though perhaps apocryphally) attributed to the economist John Maynard Keynes, who is said to have warned investors that although markets do tend toward rational positions in the long run, "the market can stay irrational longer than you can stay solvent."

Many of LTCM's strategies had payouts similar to those from selling an out-of-the-money option; a likely small gain balanced against a small chance of a large loss, compared to "picking up pennies in front of a steamroller." These strategies operated as sort of a reverse St. Petersburg lottery. Even in the particular conditions which resulted in the fund's downfall, these large losses would not, if the positions were held to maturity, have come to pass. However, the events of 1998 increased the perceived probability of large losses, to the point where LTCM's portfolio had negative value. The Optional Sampling Theorem predicts that such a situation would eventually arise, given the very no-arbitrage assumptions of the Black-Scholes model itself.

[edit] See also

[edit] Notes

  1. ^ The Bank of Sweden Prize in Economic Sciences 1997. Robert C. Merton and Myron S. Scholes pictures. Myron S. Scholes with location named as "Long Term Capital Management, Greenwich, CT, USA" where the prize was received.

[edit] Further reading

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