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Long Term Capital Management (LTCM) Back Ground
Long Term Capital Management (LTCM) Back Ground
Back Ground
Long term Capital Management was funded in early 1994 by John W. Weriwether, the former
vice chairman and head of bond trading at Saloman Brothers. Members of LTCMs board was
Myron S.Scholes and Robert C. Merton. LTCMs leaders consisted individuals who have
significant reputations in the financial markets and especially in the economies theory in the
financial market. The LTCM was the investment vehicle for a number of feeder funds, which
were structured to meet the tax, regulatory, or accounting concerns of different classes of
investors from different regions. LTCM had a prominent position in the community of hedge
funds, because of the reputation of its principals, and also because of its large initial capital stake.
The funds operation was designed to have extremely low overhead, trades were conducted
through a partnership with Bear Stearns and client relations were handled by Merrill Lynch.
Trading Strategies
LTCM pursued profit from a variety of trading strategies, including convergence trading and
dynamic hedging. The core investment strategy of the Company was involving Convergence
trading. Convergence trading , in other ward relative value arbitrage refers to the practice of
taking offsetting positions in two related securities in the anticipations that the price spread
between two securities will move in favorable direction. In fixed income. Approximately 80
percent of the LTCM Funds balance sheet positions were in government bonds of well
developed countries such as United States, Canada, France, Germany, Italy, Japan, and the
United Kingdom. On the other hand, the Fund was active in many other markets, including
securities markets, exchange traded futures, and even OTC derivatives. Fund was also
geographically diverse, covering markets in North America, Europe and Asia.
The LTCM Fund apparently had over 60,000 trades on its books, including long securities
positions of over US $ 50Bn and equal amount of short positions at the end of August, 1998, the
gross amount of the Funds contracts on futures exchanges exceeded US $ 500Bn , swaps
contract in excess of US $ 750 Bn and options and other OCT derivatives over US $ 150Bn .
Leverage
In relation with leverage, the Funds balance sheet on 31, August 1998. Included over US $ 125
Bn in assets. Even with the 1 January 1998, equity capital figure were US $ 4.8 Bn , balance
sheet assets leverage ratio was more than 25- to -01. This extent of leverage implies a great deal
of a risk.
Capital
In 1994 the LTCM Fund was launched with a capital of US $ 1Bn and at the end of 2007 capital
base increased to US $ 7.5 Bn .The Fund returned approximately US $ 2.7 Bn to its investors,
reducing the capital base of the Fund by about 36% to 4.8 Bn . Despite this reduction in its
capital base, the hedge fund apparently did not reduce the scale of its investment positions. In
other words the managers of the Fund decided to increase its balance sheet leverage by reducing
its capital base.
Returns
The LTCM Fund reported an annualized return of over 21% (after fees) in first year of its
operation, and 43% and 41% annualized returns in 1995 and 1996 respectively , however in 1997
growth momentum significantly came down to 17%. In 1998 the Fund started suffering its huge
loses.
The LTCM Funds failure
This is the era that affected the financial Market by 1997 Asian financial crisis and 1998 Russian
financial crisis.
The Fund commenced the year 2008 with a capital based of US $ 4.8 Bn , however by 31 July
1998 capital based of the Fund by 15% to 4.1Bn . During the month of August itself the Funds
suffered a capital losses of US $ 1.8Bn . TH LTCM Funds capital case was now US$ 2.3 Bn,
and the Fund announced to its investors that it was seeking an injection of capital. THE LTCM
fund suffered substantial further losses and found it difficult to reduce its positions because of the
large size of those positions. Its condition further deteriorated, previously flexible credit
arrangements became more rigid and the daily mark -to market valuations for collateral calls by
counterparties and the Fund faced the liquidity pressures.
By 21st September, the LTCMs liquidity situation was bleak. Bears Stearns, the Funds prim
brokerage firm, had required LTCM to collateralize potential settlement exposures. At this stage
with the intervention of Federal Reserve the firms participating in a consortium invested about
US $ 3.6 Bn in the equity in the Fund and acquired 90% of equity share in LTCMs portfolio
along with operational control. The principals and investors in LTCM suffered significant losses
on their equity stakes by reducing their stake to 10%.
After the bailout, the LTCM continued operations and in the following year it reported 10%
returns. By early 2000, the Fund was liquidated, and the consortium of banks that financed the
bailout was paid back.
Lessons Learned
The lessons to be learned from this crisis are Market values matter for leveraged portfolios,
Liquidity itself is a risk factor, and Models must be stress-tested and combined with judgement.
Initial margin are always required regardless of the firms reputation. Unexpected correlation or
the breakdown of historical correlations, the value of disclosure and transparency, the danger of
over-generous extension of trading credit, the woes of investing in star quality and investing too
little in game theory.