HBS Case: Long-Term Capital Management, L.P.

(A)

1) Are the incentives of the Principals and employees of LTCM aligned with investors? The incentives for the principals and employees of Long Term Capital Management (LTCM) are aligned with investors. Principals and employees structured Long-Term Capital Portfolio, L.P. (the fund) using three main tools to align interests: (i) a high employee ownership in the fund; (ii) a fee structure heavily weighted towards an incentive or performance fee; and, (iii) the matching of the funds liquidity with the long-term investment horizon of most of the underlying trade. The first component is the single most important factor in evaluating employee incentives. By having LTCM employees invest their capital alongside investors it automatically aligns interests. LTCM employees capital accounted for almost twenty-five percent of the funds total capital. Most of the employees of LTCM elected to contribute to the funds deferred-compensation plan, which was also linked to the underlying performance of the fund. Additionally, principals reinvested almost all of the company earnings back into the fund. This creates large incentives for the employees of the fund to run the fund in a prudent manner and earn the best risk adjusted return for themselves as well as their Limited Partners. The second critical area of keeping incentives aligned is LTCMs fee structure. The fund charges a two percent management fee on assets under management and a twenty-five percent performance fee on all returns over the high-water mark of the fund. The management fee of two percent is at a competitive rate, is the standard management fee charged across the hedge fund universe and is meant to cover the operations of the management company. The twentyfive percent performance fee is a bit on the high side, but the fund has a high-water mark in place and the historical returns the fund has achieved provide support for higher performance fee. LTCM can only charge the performance fee above the funds high-water mark. Losses must be recouped prior to the fund charging the twenty-five percent incentive fee. The incentive fee keeps management focused and motivated to drive the performance of the fund and avoids having management just collect a management fee by sitting on underperforming assets. Thus, the funds fee structure is setup in a way that LTCM must perform to earn large profits. The third component that helped align all investor interests is the liquidity terms of the fund. The funds three-year lock fits the long-term investment horizon of the arbitrage strategies

the fund is used. The liquidity terms keep the interests of all investors in mind as the fund only allows for staggered maturities or redemptions. Thus, the fund can prevent massive runs on its equity base, which would otherwise force the fund to sell positions at discounts and hurt all investors in the fund. 2) Describe the view that motivates the swap spread trade. How can this trade lose money? The view motivating the swap spread trade is that dislocations in the financial markets lead to a mispricing of various securities. Investors can capitalize on this mispricing through arbitrage opportunities. In the case of LTCM, the company was able to capitalize on arbitrage opportunities when the swap spread was sufficiently narrow or wide. The swap spread is the spread between the fixed rate on the swap and the yield on a treasury bond of comparable duration. LTCM borrowed funds at the repo rate and lent at a fixed rate. The profitability of the trade depends on the cost of financing the purchase of Treasury Bonds. Whether a swap-spread trade creates a loss or gain depends on whether one is purchasing the fixed or floating rate and the spread on the swap instrument. A trade where one is paying fixed to receive floating can lose money in two scenarios: (i) when swap spreads narrow and the fund does not have sufficient liquidity; and, (ii) when financing rates on bonds deteriorate relative to the London Interbank Offered Rate (LIBOR). In the first scenario, the narrowing of swap spreads does not in itself necessitate a loss. A narrowing of the swap spread causes the value of a bond portfolio to go down because bonds mark-to-market every day. If the position is held until maturity, the bonds issued are repaid at par so any mark-to-market losses suffered during the time of the contract would be irrelevant. Using the example on page 4 of the case, if the fund can hold the position to maturity it will make the positive carry of 3 basis points per year. However, if the fund had liquidity problems and needed to unwind the position prior to maturity, the loss on the portfolio value (as a result of narrowing swap spreads) would be realized. The second scenario involves periods where the financing rate on bonds deteriorates relative to LIBOR. In this case, it will be more expensive to borrow funds (i.e., the repo rate increases relative to LIBOR) and thus the positive carry on the trade could evaporate.

3) Describe the fixed-rate mortgage trade. How can this trade lose money? Mortgages are typically hedged with either or a combination of Treasury Futures, Eurodollar Futures or Swaps. How is LTCMs view on swap spreads reflected in their choice of hedge instrument? How would you hedge mortgages when swap spreads are extraordinarily wide? Or when swap spreads are at a normal/fairly priced level? The fixed-rate mortgage trade involves taking a long position in fixed-rate residential mortgage-backed securities (RMBS) and hedging out any interest-rate exposure, normally with interest rate swaps. Since RMBS have prepayment risk (that is, homeowners inconveniently tend to refinance or prepay their mortgage when interest rates fall, but hold onto their mortgages when interest rates rise), the analysis of RMBS is more complicated than other fixed-income securities and sophisticated prepayment models are needed to properly value the securities as well as the underlying mortgage pools. As a result of the embedded prepayment option within the underlying mortgages, RMBS trade at significant spreads to LIBOR (as high as 25 basis as indicated in the case). At the same time the RMBS are collateralized by the borrowers homes and presumed to be backed by the full faith and credit of the United States government (as they are financed by the quasi-government mortgage agencies, which have an implicit backing by the U.S. government), making the instruments essentially default free. As a result, LTCM could finance RMBS at low rates (LIBOR minus 12.5 basis points with 2% haircuts) and therefore could benefit from the positive carry it could create between the spread on the RMBS and the rate at which the securities could be financed. Thus, when LTCM found a RMBS whose market value deviated materially from the fair value of the security calculated with the firms prepayment model, the company could buy the RMBS with 100% financing, hedge out the interest-rate risk and benefit from the positive carry created on the trade. The fixed-rate mortgage trade could lose money in a numbers of ways: (i) prepayments on the underlying mortgages might be substantially larger than those predicted by LTCMs prepayment model causing the return on the RMBS to be less than expected; (ii) due to liquidity issues, the trade might have to be unwound before the market value of the RMBS converges to the value calculated by the LTCMs prepayment model; and, (iii) the financing for the trade may be more expensive than originally estimated causing the positive carry on the trade to disappear. LTCMs view on swap spreads is reflected in their choice of hedge instrument because RMBS can be hedged with multiple instruments (Treasury Futures, Eurodollar Futures, swaps or a combination of all three securities). Thus, when swap spreads are extraordinarily wide (most

likely due to the credit risk element in LIBOR rates), LTCM would decide to hedge RMBS using Treasury Futures or Eurodollar Futures as the wider swap spreads would push up borrowing costs and cut into the positive carry of the fixed-rate residential mortgage trade. On the other hand, when swap spreads are at a normal or fairly priced level, LTCM would use interest-rate swaps to hedge RMBS rather than Treasury Futures or Eurodollar Futures as the swaps are cheaper and easier to use as a hedging instrument. 4) Describe how LTCM sells volatility in the fixed-income and equity option products. How can this trade lose money? How can the mortgage trade also be characterized as selling volatility? LTCM sells volatility by selling long-maturity put and call options on stock market indexes. The buyers of these options would repackage the purchased options into structured products. LTCM looked to capitalize on what they believed was a short-term mispricing in the options market. LTCM priced the options based on historical volatility assumptions. In the case of equities, the strike price was equal to the forward price of the index. The forward price depended on a variety of factors including the expected volatility of the index. LTCM believed that expected volatility, as seen in near-term index option prices, was higher than the actual volatility. They believed this was caused by investor nervousness due to struggles in the Asian economy, which in turn had created a greater demand for downside protection. Thus, LTCM believed they could sell options with significantly higher implied volatilities than both the historical and implied volatilities on short-term options that were observed in the market. This is exemplified in page 8 of the case; historical volatility was 10-13% but near-term options were pricing consistent with volatility of 20%. The trade loses money if the actual volatility is higher than the implied volatility of the options. In this case, LTCM did lose money because volatility jumped well above the implied level of 20%. In addition, some of the funds mortgage trades involved a long position in interest only strips (IO), with interest-rate risk hedged through swaps. A mortgage-backed security can be viewed as purchasing a non-callable bond and selling a prepayment option. Selling a prepayment option is equivalent to selling volatility as discussed above. As interest rates go down, the risk of prepayment by the homeowner goes up causing the price of the IO position as well as the volatility of the prepayment option to go down, thus reducing the cost of the option. LTCM felt that the price of current options was too low based on their prepayment models and

thus had the ability to capitalize on arbitrage opportunities in the market by selling options. 5) Discuss risk management at LTCM. How does value at risk limit loss exposure? What information does stress testing provide? What is the effect of correlation among trades on portfolio risk? How can you test LTCMs correlation assumptions with the data in Exhibit 1? LTCMs risk management seemed to concentrate too much on theoretical market-risk models, such as VaR and volatility predictions, rather than stress testing for the underlying positions or managing the funds liquidity risk. Value at risk (VaR) is defined as the worst loss than can happen under normal market conditions over a specified horizon at a specified confidence level; it is a probabilistic measure of loss potential to a specified level of statistical confidence. Thus, a 95% VaR indicates that there is a 5% chance that a loss greater than a certain value would be sustained in a certain time period. VaR can limit loss exposure, because the fund can set risk limits for the maximum amount of risk it is willing to take over a certain time period and ensure it stays within these risk limits by measuring the portfolios VaR. However, this approach to risk management assumes that the variances and correlations between positions do not change over time (i.e., future movements in risk factors are similar to past movements) and are assumed to be normally distributed. However, the assumption for static risk factors does not always hold, especially during times of crisis when the correlations between most trades increase. Stress testing involves simulating significant past events and different future events on the trades within the fund to understand the underlying profit and loss from the portfolio over different time frames as well as the returns for the portfolio under various scenarios. With stress tests, a risk manager normally explores cases where they do not have enough data to estimate the risk accurately in the hope that by preparing for foreseeable events they can acquire the discipline to survive such events if they actually occur. Thus, by performing stress tests on the portfolio, LTCM could assess the effects of changes in economic factors such as interest-rate movements, yield-curve shifts or stock price movements, on the economic profit and loss of the fund and use such information to determine the funds need for capital to support its positions. The effect of correlation among trades on portfolio risk is significant as demonstrated by Exhibit 3 of the case in which the portfolio risk for ten positions that are perfectly correlated is 1,000%, with each position adding an incremental risk of 100%, whereas the portfolio risk for

ten positions that are perfectly uncorrelated is only 316%, with the tenth position adding only incremental risk of 16%. Thus, while LTCMs portfolio generally benefitted from diversification, as the profits from the firms diversified trading strategies were generally uncorrelated, the benefit vanished in August 2008 due to the general flight to liquidity in the capital markets. This general flight to liquidity led to a market-wide re-pricing of risk, which ultimately increased the correlation between the funds positions. Diversification was no longer helpful in reducing the funds risk as the value of nearly all the funds positions (and all asset classes in general) was moving in lockstep. Thus, as the case indicates, the fund suffered large losses to its equity value as the correlation of the firms positions increased. As John Maynard Keynes is known to have said, the market remained irrational for a longer time-period than the fund could stay solvent. 6) In September of 1997, the Principals debated whether or not the Fund had excess capital. What course of action should they take? LTCM assets under management grew from $1.1 billion in 1994 to $6.7 billion in August of 1997. The enormous size of the fund began to impede LTCMs investment strategy. LTCM had become too large for the arbitrage markets that it operated in. As a result, the fund began having difficulty sizing in and out of trades without moving prices, which left profits on the table and caused liquidity issues. Furthermore, the funds size prevented LTCM from having the ability to be nimble and respond to changes in the market. This sent red flags to management that the fund had grown too large. To restore scalability to the fund, LTCM should have a hard close on the fund at yearend. The principals should not allow any additional capital, old or new, to be contributed to the fund. LTCM should also return capital to investors by orderly unwinding positions and distributing 50% of all assets back to investors. Additionally, LTCM should use its core competencies and form a new fund focused on a slightly different strategy and market. The new fund would have the opportunity to attract a large amount of seed capital from existing or new investors whose capital was turned away as a result of the funds closure.