LTCM

Introduction
Long-Term Capital Management (LTCM) was a hedge fund founded in1994 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. Initially enormously successful with annualized returns of over 40% in its first years, in 1998 it lost $4.6 billion in less than four months and became the most prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000.

Strategies used by LTCM

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, they felt pressed to invest that capital somewhere and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise. 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. Because these differences in value were minute especially for the convergence trades the fund needed to take highly- leveraged positions 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.

Initial performance
The LTCM fund had immense returns the first two years i.e. nearly 40% and more. This was made possible through leverage positions. In theory, the leverage should not increase the market risk which the fund faces if the securities are liquid Hedge Funds often pay back the return to their investors not to become too large. In 1997 LTCM returned $2.7 billion to its investors. However, they did not decreasing the position in the market thus the leverage increased. They also started to add other risks by entering

Deepak Chaplot

10BSP1441

FRM

LTCM different markets to sell options on stock indices and to invest in bonds from Emerging Markets especially Russia. Below table shows the return of LTCM : Year 1994 1995 1996 1997 Net Return 20% 43% 41% 17% Gross Return 28% 59% 57% 25%

1997 Downturn
Although success within the financial markets arises from immediate-short term turbulence, and the ability of fund managers to identify informational asymmetries, factors giving rise to the downfall of the fund were established prior to the 1997 East Asian financial crisis. However, in May and June 1998, net returns from the fund in May and June 1998 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. Such losses were accentuated through the Russian Financial Crises in the August and September of 1998, when the Russian Government defaulted on their government bonds. 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 Flightto-Liquidity. In the first 3 weeks of September LTCM's equity tumbled from $2.3 billion to $600 million without shrinking the portfolio, leading to a significant elevation of the already high leverage. Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $4 billion and to operate LTCM within Goldman Sachs's own trading. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bail-out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The total losses were found to be $4.6 billion. The losses in the major investment categories were : $1.6 bn in swaps $1.3 bn in equity volatility $430 mn in Russian and other emerging markets $371 mn in directional trades in developed countries $215 mn in yield curve arbitrage $203 mn in S&P 500 stocks $100 mn in junk bond arbitrage

y y y y y y y

Deepak Chaplot

10BSP1441

FRM

LTCM

Federal Reserve Intervenes

To save the U.S. banking system, the Federal Reserve Bank of New York President William McDonough William J. McDonough convinced 15 banks to bail out LTCM with $3.5 billion, in return for a 90% ownership of the fund. In addition, the Fed started lowering the Fed funds rate as a reassurance to investors that the Fed would do whatever it took to support the U.S. economy. Without such direct intervention, the entire financial system was threatened with a collapse.

Conclusion
From the above case, we should follow the following Measures when assessing the risk of a hedge fund: y Include due diligence assessments of the financial soundness and managerial ability of the counterparty, including its risk profile. y Require ongoing disclosure of financial reports, supplemented by information on the prospective volatility of the counterpartys positions, as well as qualitative reports. y Impose collateral requirements to cover potential credit exposures when insufficient information is available on counterpartys creditworthiness. y Should have its own credit limits on counterparty exposures. y Should have ongoing monitoring of counterpartys financial position.

Deepak Chaplot

10BSP1441

FRM