IndexLong Term Capital Management LP A Case StudyHedge Funds and the Uniqueness of LTCMInvestment StrategiesWhat Went WrongLTCM Collapse and Possible CausesHow the Fed Saved LTCM and Why They Did It Importance LTCM InternationalLessons LearnedSummaryLong Term Capital Management LP A Case StudyRarely, if ever, has a single company had such a dramatic impact on the international economy as Long Term Capital Management LP (LTCM). This report describes the company itself and its investment strategies, with particular attention to its international influence and importance. LTCM's activities in the financial world eventually caused the near collapse of the entire international financial system. Indeed, if the Federal Reserve Bank of New York (FRBNY) had not stepped in to coordinate a major acquisition of LTCM after it plunged into insolvency, the entire financial system could have been seriously jeopardized. Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Get an original essay Set up as a particularly large hedge fund and staffed by Ph.D. economists and established Wall Street bond traders, LTCM is a very interesting case, as well as an extremely volatile and important fund. Founded in part by Nobel Prize winners Robert Merton and Myron Scholes, LTCM based its investment strategies on mathematical models developed by Scholes, Merton and Fischer Black. The model itself, commonly known as the Black-Scholes options pricing model, is famous for two important insights into economic thinking. First, the model determines how to eliminate risk as a variable in the options pricing equation. This was achieved thanks to the second important insight, namely the idea of ​​using continuous time for option pricing instead of second-by-second timing, a crucial element that Robert Merton borrowed from a Japanese rocket scientist named Ito. Figuring out how to take the risk out of large-scale investing is obviously a huge step forward that puts greed in people's eyes and pushes major investment players to fight for the chance to invest where the model will be used for the first time in the practice. Integrating the notion of continuous time into the pricing model eliminated the problem of an appropriate option price being obsolete by the time it was calculated. As advocates of these powerful tools, Merton and Scholes decided to play the very financial markets that had already been transformed by their insights. The Black-Scholes model is: Value of a call option = P0N(d1) - X [N(d2)]eKRFtWhere Po = the current price of a stock until expiration the optionKRF = continuously compounded risk-free interest ratee = the natural antilogarithm of 1.00 or 2.71828N(d) = the probability that a standardized, normally distributed random variable has a value less than or equal to, essentially hedge ratios.1 The Black-Scholes pricing model can adjust the value of options to reflect ongoing changes in stock prices. Black, Scholes and Merton seemed to have made the breakthrough that could finally bring perfect efficiency to world markets. John Meriwether, a wealthy and famous Wall Street bond trader from Soloman Brothers Inc., also played an integral role in the company's history. Meriwether left Soloman after his name became too closely associated with a bond auction fraud scandal orchestrated by one ofhis colleagues. Meriwether, an old friend of Scholes, brought his experience in bond markets and bond futures to the company as a top executive. Also a co-founder, Meriwether brought with him to Soloman many of his former colleagues, who had left Soloman after the bond fraud scandal in 1992. Hedge Funds and the Uniqueness of LTCMA The hedge fund is organized much like a mutual fund (both are private and pooled investment accounts), but with some significant differences. Legally, a hedge fund is distinguished by the fact that it limits the number of investors to 500 per fund. Additionally, to qualify to invest in American hedge funds you need a minimum capital amount of $5 million for individuals and $25 million for institutional investors. In the case of LTCM, only individuals and institutions sought by the funds' partners were allowed to invest in the company. Other things that distinguish hedges from mutual funds are: Hedge fund managers have almost complete autonomy in determining which assets to hold and are not at all limited in the types of assets they can hold. Hedge funds may engage in short selling. Hedge funds can use leverage to increase levels of funding and risk and return. Hedge funds can limit the amount of cash injected into and withdrawn from the fund by its investors.2LTCM has therefore been able to engage in virtually any investment strategy its managers choose. The founders of the funds were not subject to any rules regarding the types of assets they could hold in the fund, including derivative securities, margins, bond futures and currencies. Fund managers could also short-sell assets at will. Many believe that excessive use of leverage has become a serious problem for LTCM. Proponents of this theory even believe that excessive leverage caused the funds to collapse. The term hedge fund is essentially a misnomer, as it sounds like a hedge but is almost the opposite idea. Hedging refers to investment strategies that reduce the risk associated with owning financial assets, usually through the use of derivatives. A hedge fund is a large, privatized pool of investment money that is normally invested in high-risk securities. LTCM was not your average hedge fund. He mainly used arbitrage techniques and strategies between bonds and bond futures derived from the mathematical insights provided by the Black-Scholes model which allowed them to continuously monitor the real value of the derivative securities. The sheer scale of their investments also set them apart. Starting with initial capital of around $4 billion, the fund quickly grew to a maximum position of $1.2 trillion. The institution's risk management practices consisted of attempting to eliminate risk by continuously adjusting its holdings to react to constant changes in market prices. When LTCM nearly collapsed, the partners themselves personally lost $1.9 billion, of the total $4.4 billion lost by the fund (see pie chart of losses). Investment Strategies Using seemingly foolproof arbitrage techniques, LTCM used excessive leverage to amplify its gains. . Contrary to myth, hedge funds are not all highly leveraged. LTCM often had debt equal to about thirty times its capital, and the institution mainly borrowed from the same companies that had invested in it. Many companies have invested in LTCM under the assumption that LTCM strategieswere foolproof. 3LTCM essentially engaged in the types of trades that no one else would think of, and because of this, it quickly became the firm to watch and emulate for many fund managers. . In fact, some believe this mirroring of investment strategies contributed to its collapse. LTCM was primarily concerned with placing trades in bond markets where pricing is still somewhat inefficient.4 The institution bet on interest rate spreads between corporate bonds and government bonds. and on the volatility of the markets. LTCM used the Black-Scholes pricing model and other cutting-edge pricing techniques to see which bonds were undervalued and which were overvalued according to those mathematical models, and then placed its bets accordingly. The firm observed the differences between government bonds and corporate bonds, and when the difference was believed to be at its peak, it bought relatively cheap corporate bonds and shorted relatively expensive government bonds. When the gap between the two narrowed, the fund profited, but if the gap widened further, the fund would suffer a loss. However, in the case of LTCM, the sheer scale of investments the company was making could often push rates in the direction desired by LTCM.5 bonds (OAT) and German bonds (bund). According to parties associated with LTCM, the fund engaged in dozens of cash and futures transactions, interest rate swaps, currency forwards and options. . . to build a $10 billion position.6 When the spread between OAT and bunds reached 60 basis points in the futures market, LTCM decided to double its position. Another competing arbitrageur claims that this deal was actually just one leg of an even more complex convergence bet, which included hedged positions in Spanish peseta and Italian lira bonds.7 LTCM reportedly derived about a third of its profits from an Italian tax arbitrage agreement from which many other arbitrageurs also took advantage.8 LTCM stood out in its trading strategies mainly for two things; the thoroughness of preparations for the operations carried out and the propensity of the fund to invest abnormally large amounts of money in profitable operations. With all these factors working in the company's favor, it is difficult to see how LTCM could fail so miserably and suddenly. What Went Wrong In September 1998, LTCM found itself in a crisis situation. The institution appears to have underestimated the implications of short-term liquidity problems.9 Shortly after falling into insolvency, the Federal Reserve Bank of New York rescued the company from bankruptcy. Collapse of LTCMs and Possible Causes It is impossible to determine with certainty what specific factors caused the collapse and near disappearance of LTCMs. Many argue that the excessive leverage used by the fund (around 30 times their capital) over-amplified their losses when they started losing money.10 Furthermore, LTCM relied on an academic pricing model that eventually revealed a pattern applicable only during normal times. market conditions and not in extreme conditions. Increased risk and theoretical economics certainly played a role in LTCMs nearing their end. Another contributor was the global financial crisis of September 1998. There were two likely smoking guns of that particular global financial anomaly. The first was the currency reform in Thailand and the resulting devaluation of the national currency. The second was theRussian government default on its debts, which dried up the liquidity associated with the ruble and Russian financial assets. In mid-1998, Thailand switched from a fixed exchange rate system to a floating rate system. When the demand they expected for their assets failed to materialize, the value of their currency plummeted. This led to the collapse of some large Asian banks that held significant stakes in Thailand, which led to a general and rapid economic recession in Asian countries where LTCM had outstanding interest rate options. Around the same time, Russia, another country with which LTCM had pending currency bets, was in the midst of an economic collapse. The social uprising against the communist government has brought the discretion and control of Russian fiscal policy to its knees. When the Russian government defaulted on its debts, the market reaction was predictably catastrophic and LTCM, among others, lost all its interests in Russia. The one in a million chance of these types of events occurring simultaneously materialized. LTCM had made itself particularly susceptible to losses in this type of situation. When a hedge fund arbitrages between the currency bonds of several large economic nations and the futures on those bonds, a major collapse in one of those nations can set off a domino effect with the potential to destroy all players involved, essentially drying up liquidity in thoseactivities. For example, if LTCM bets on rising interest rates in Japan, and they do, LTCM will assume they are in the money on that deal. They will use the money they have not yet received to secure similar interest rate bets with, for example, Germany. So, if Japan defaulted on the money owed to LTCM, the German options it had secured would also run out. The German institution with which LTCM traded will also find itself without the money it expected to receive from LTCM. It is therefore clear that the supply and demand for liquidity of financial assets are the basis of LTCM's investment strategies. LTCM relied on the global diversity of its holdings, assuming that global diversification negates all risk.11 But correlation between global markets tends to amplify upward in times of distress, reflecting the economic linkages between markets and factors social. LTCM representatives believe that the company's near collapse was the result of two phases of external panic.12 First, Wall Street firms began to doubt LTCM. The social panic followed the market panic of Wall Street companies. Rumors spread that LTCM had weakened. LTCM believes that other companies have used their weakness as an opportunity to strengthen themselves. Wall Street firms began duplicating LTCM's investment strategies, weakening LTCM's market position. The institution was weak and owned a huge portion of the market. Of course, other companies would like to destroy LTCM to strengthen their own positions. Another suggested contribution to the near-collapse of LTCM is as follows. A large number of positions in the LTCM portfolio depended on a narrowing of the spread between two related securities (i.e., hedging two securities). This means that investors take a long position (i.e. buy) the higher yielding stock and take a short position (i.e. sell) the lower yielding stock and hope that the spread narrows. When using substantial leverage, the spread can be extremely profitable if the spread ratio remains constant or narrows. In effect, betting on market volatility in this wayleads to a “catch 22” situation. A firm bets on volatile markets and will profit when they are, but buying derivative securities such as volatility swaps and straddles is a zero-sum game. When the firm makes money, its counterparty loses, which makes the firm less likely to collect its money because the loss could drive the counterparty into bankruptcy. This is called counterparty risk and LTCM was certainly affected as liquidity in the Russian and Asian markets dried up. If liquidity had been available, LTCM could have survived. Therefore, the problem was not necessarily the leverage used by LTCM; the lack of market liquidity may have been a more direct cause of the funds' failure. At the same time, other companies with similar operations were trying to narrow these spreads. This caused spreads to widen, resulting in large losses by banks and highly leveraged hedge funds like LTCM.13LTCM lost money at unprecedented rates. After returning more than 40% for three consecutive years, the fund lost $500 million on two consecutive days.14 Very few, if any, companies have enough liquidity to not be overwhelmed by a $1 billion loss in a period of 48 hours. LTCM suddenly became insolvent and the value of portfolios continued to collapse due to psychological market reactions (e.g. loss of confidence, change in credit rating). In a six-week period between August and September 1998, LTCM lost approximately $4.4 billion and would have declared bankruptcy if not for the FRBNY's intervention. How the Fed Saved LTCM and Why It Did It The FRBNY saved LTCM from bankruptcy by consolidating fourteen American investment banks and securities firms collectively bailed out LTCM for $3.625 billion in September 1998. The company still exists and John Meriwether is now involved in repaying slowly many of the initial investors' funds to what Myron Scholes calls a no-fault failure. 15Why did the Fed go to so much trouble to save this particular company? What would he gain this way? What was he trying to accomplish or avoid? The answer is that, after conducting an audit of LTCM's books, the FRBNY recognized the strategic importance of this company's international financial position. The FRBNY feared that the default of the LTCMs could pose a grave danger to the entire international financial system due to the size, nature and complexity of the wealth they had spread around the world. The international importance of LTCM investments is discussed in the following section. International Importance of LTCMLTCM had spread its investment position across 75 different nations, in order to avoid concentrating risk in a certain area. it almost created an international catastrophe. However, this also worked to LTCM's advantage, as the Fed would not have bailed them out if they were not so widely diversified and internationally important. However, LTCM's financial well-being was not of direct concern to US regulators. Rather, the FRBNY bailed out LTCM to prevent the potential direct and indirect effects of LTCM's failure on other financial markets and institutions around the world.17 Direct losses, such as those suffered by LTCM's credit positions and equity owners, would have been probably controllable, but still not a concern of the FRBNY. However, the Fed was concerned about the consequences of the LTCM default on the functioning of the financial system, i.e. the associated systematic effects..