FUTURE, OPTION & OTHER DERVIVATIVES

TOPIC NUMEBR .2.

LONG TERM
CAPITAL MANAGEMENT

Presented To: Presented By:

Mr. Pushkal Pandey Avijeet
Kumar
Atul Jain
 INTRODUCTION


 LTCM was founded in 1994 by John Meriwether, the former vice-

chairman and head of bond trading at Salomon Brothers. Board of
directors members included Myron Scholes and Robert C. Merton, who
shared the 1997 Nobel Memorial Prize in Economic Sciences.


 Initially enormously successful with annualized returns of over 40%

(after fees) in its first years, in 1998 it lost $4.6 billion in less than four
months following the Russian financial crisis and became a prominent
example of the risk potential in the hedge fund industry. The fund folded in
early2000.
 FOUNDING
 In 1993 he announced that he would launch a hedge fund called
Long-Term Capital.
 Meriwether used his well-established reputation to recruit several
Salomon bond traders and some brilliant mathematicians.
 He also recruited two future Nobel Prize winners, Myron
Scholes and Robert C. Merton.
 In late 1993, Meriwether approached several "high net-worth
individuals" in an effort to secure start-up capital for Long Term Capital
Management. With the help of Merrill Lynch, LTCM secured hundreds of
millions of dollars from business owners, celebrities and even
private university endowments. The bulk of the money, however, came
from companies and individuals connected to the financial industry. By 24
February 1994, the day LTCM began trading, the company had amassed
just over $1.01 billion in capital.
• Pairs trading is a strategy that uses two highly
correlated financial instruments (eg Coca-
Cola and Pepsi) whose price relationship has
divergerged outside of the historical range. In
buying one and selling the other, the strategy
aims to profit from the price reverting back to
as the mean trend as the spread between the
two converges.
• Fixed-income arbitrage is primarily used by
hedge funds and leading investment banks.
The most common fixed-income arbitrage
strategy is swap-spread arbitrage. This
consists of taking opposing long and short
positions in a swap and a Treasury bond. Such
strategies provide relatively small returns
and, in some cases, huge losses.
 TRADING STRATEGY


 The company used complex mathematical models to take advantage

of fixed income arbitrage deals (termed convergence trades) usually with
U.S., Japanese, and European government bonds. Government bonds are a
"fixed-term debt obligation", meaning that they will pay a fixed amount at
a specified time in the future.


 CONVERGENCE MEANS
 Arbitrage has the effect of causing prices in different markets to
converge. As a result of arbitrage, the currency exchange rates, the price
of commodities, and the price of securities in different markets tend to
converge to the same prices, in all markets, in each category. The speed at
which prices converge is a measure of market efficiency. Arbitrage tends to
reduce price discrimination by encouraging people to buy an item where
the price is low and resell it where the price is high,
LTCM DOWNTURN FACTORS
 IMPACT ON LTCM
• EAST ASIAN FINANCIAL CRISIS
 Because of the1997 East Asian financial crisis. In May and June 1998
returns from the fund were -6.42% and -10.14% respectively, reducing
LTCM's capital by $461 million.


• RUSSIAN FINANCIAL CRISIS

 The Russian financial crises in August and September 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.
•
 EAST ASIAN FINANCIAL
CRISIS
•
• Asia attracted almost half of the total capital inflow to developing
countries. The economies of Southeast Asia in particular maintained
high interest rates attractive to foreign investors looking for a high rate
of return.
• As a result the region's economies received a large inflow of money and
experienced a dramatic run-up in asset prices. At the same time, the
regional economies of Thailand, Malaysia, Indonesia, Singapore,
and South Korea experienced high growth rates, 8–12% GDP, in the
late 1980s and early 1990s.
• This achievement was widely acclaimed by financial institutions including
the IMF and World Bank, and was known as part of the "Asian
economic miracle".
 CAUSES OF EAST ASIAN
CRISIS


 In the mid-1990s, Two factors began to change their economic

environment.
1. The U.S. economy recovered from a recession in the early 1990s, the U.S.
Federal Reserve Bank under Alan Greenspan began to raise U.S.
interest rates to head off inflation.
2. For the Southeast Asian nations which had currencies pegged to the U.S.
dollar, the higher U.S. dollar caused their own exports to become more
expensive and less competitive in the global markets.


 And because of this Southeast Asia's export growth slowed

dramatically in the spring of 1996, deteriorating their current account
position.
 RUSSIAN
•
 RUSSIAN INCOME
•
• Petroleum, natural gas, metals, and timber accounted for more than 80% of
Russian exports, leaving the country vulnerable to swings in world
prices. Oil was also a major source of government tax revenue.
•
 FACTOR FOR RUSSIAN FINANCIAL CRISIS


• The Asian financial crisis that had begun in 1997 and this crisis declines in
demand and price for (and thus price of) crude oil and nonferrous
metals, impacted Russian foreign exchange reserves.
OIL PRICES

Almost 10 USD /barrel

 RUSSIAN FINANCIAL CRISIS
•
• Two external shocks, the Asian financial crisis that had begun in 1997 and
the following declines in demand for (and thus price of) crude
oil and nonferrous metals, impacted Russian foreign exchange reserves.
• A political crisis came to a head in March when Russian president Boris
Yeltsin suddenly dismissed Prime Minister Viktor Chernomyrdin and
his entire cabinet on March 23.
• In June Kiriyenko hiked GKO interest rates to 150%.
• On August 13, 1998, the Russian stock, bond, and currency markets
collapsed as a result of investor fears that the government would
devalue the ruble, default on domestic debt, or both. Annual yields on
ruble denominated bonds were more than 200 percent.
CRISIS
LTCM CRISIS
 ILLUSTRATION
•
• Lowenstein reports that LTCM established an arbitrage position in
the dual-listed company (or "DLC") Royal Dutch Shell in the summer
of 1997, when Royal Dutch traded at an 8-10% premium relative to
Shell. In total $2.3 billion was invested, half of which long in Shell and
the other half short in Royal Dutch. LTCM was essentially betting that
the share prices of Royal Dutch and Shell would converge. This may
have happened in the long run, but due to its losses on other positions,
LTCM had to unwind its position in Royal Dutch Shell. Lowenstein
reports that the premium of Royal Dutch had increased to about 22%,
which implies that LTCM incurred a large loss on this arbitrage
strategy. LTCM lost $286 million in equity pairs trading and more than
half of this loss is accounted for by the Royal Dutch Shell trade.
 BAILOUT PACKAGE
•
•
•
•
• On September 23,Goldman Sachs, AIG, and Berkshire Hathaway offered
then to buy out the fund's partners for $250 million, to inject $3.75
billion and to operate LTCM within Goldman's own trading division.
The offer was stunningly low to LTCM's partners because at the start of
the year their firm had been worth $4.7 billion. Buffett gave
Meriwether less than one hour to accept the deal; the time period lapsed
before a deal could be worked out