Introduction

In the case of Long-term capital management, one can find the rise and fall of hedge

funds in the past two decades. It exhibited a vivid image of Wall Street where its fund managers

ambitiously leveraged their portfolios and provided extremely high returns and fell to lose

clients’ money “all of sudden.”

Background information

Hedge fund industry is a deregulated one comparing to mutual fund and other investment

firms. It had not been enforced by law to notify its clients with investment strategies or change of

portfolios while management fee was named by hedge funds. The nature of its secret of

investment strategy was no different than investing in mispricing financial products and earns

profit at the spread of borrowings and return of investment.

In early 1994, the former vice president of Salomon Brothers John Meriwether resigned

from his post because of failure of regulating his traders. He soon started Long-term capital

management (LTCM) that recruited several experienced elites partners including an Economic

Nobel Prize winner and former vice chairman of Federal Reserve. It expanded at super speed that

on its first day, LTCM raised capital of $1.3 billion from all over the globe including Bank of

Italy and other investment banks. Its founding partners also contributed $100 million. LTCM

required its clients to have a lock up period of three years with a minimum of $10 million and it

will charge 2% of the funding and keep 25% of the profit. Such tight restriction was not irritating

investors, by 1997, LTCM held a total funding of $7 billion in total. LTCM performed

outsmarted its competitors; it delivered $2.7 billion in total return to its clients.As its success

came along, LTCM was confident and searched for more return. Its leverage ratio had piled up to

30%. (See exhibit 1)

Analysis

LTCM was no different than other financial institutions, it aimed to find mispriced

financial products, invested them with proper hedges on the side. LTCM longed undervalued

assets and sold short similar assets that were slightly overvalued. It used pair trade accordingly.

It also provided more utility while the wait of convergence or the spread to generate profits and

this arbitrage technique seemed to be fairly valued at low risk after all. Three essential pillars

were adopted by LTCM: Leverage enabled by repo financing and controlled by Value-at-Risk.

LTCM used high leverage ratio to enhance its performances. In the article, one can find

that by year of 1998, LTCM’s leverage ratio had boosted to 2500%. At that time, its assets were

$5 billion and its borrowed funding worth about $120 billion. LTCM would make a profit at the

spread at rate of financing and return of investment. (Example see exhibit2)

To pile up its capital, LTCM used repo financing which meant to repurchase agreement

between two parties overnight, and LTCM would repurchase the asset the next trading day. That

would allow LTCM possessed more capital to invest in higher yield assets. Rolling over this

process 25 times was common for LTCM. One thing was to remember LTCM always took these

opportunities to invest where there exist spreads between assets.

LTCM had a well functioned risk department. It reported to superior on a daily basis of

summary on Value at risk. It provided the worst scenarios that the maximum loss at particular

investment at a particular period of timeline overall. The model was built to avoid major market

shock where “Black Swans” could happen.

The product that LTCM concentrated on was fixed income securities. It searched for

global mispricing securities and macro investment opportunities. In domestic trading, it focused

on arbitraging US Government bonds. Its main strategy called “on the run” for “off the run” in

long term US treasuries. LTCM found short term US government bond maturing in six months

were generally slightly overpriced which investors would pay premium of its possession. On the

other hand, LTCM found long term US government bond maturing in thirty years were generally

slightly undervalued. There existed a spread. Because of different yields, LTCM longed cheaper

bonds yield higher and short sold more expensive bonds yield lower at once. The spread created

space for arbitrage opportunities.

The general of arbitrage proceeded in the following order: LTCM short sold $1 billion

worth of thirty year treasury bills at price of $998 per contract, this gave LTCM $998 million

cash if the hair cut was 1% and interest rate was 4%. Then LTCM would clear its position by

repurchasing them back at a lower price. Then it would long thirty year treasury bills with a repo

agreement with other financial institutions that haircut and interest was set to receive cash. Then

it would sell them.

Another derivate was swapping on interest rate spreads. It was designed to provide

convergence with exposure of low risk. It was concentrated to find the spread between long

positions in treasury bills by financing with a floating rate. Two scenarios were presented:

1) Low swap spread: The spread between fixed interest rate payment on swap and identical asset

was lower according to historical data, LTCM would repurchase with repo, the cash flow

generated would be:

(Treasuries yield − fixed swap interest rate) + (LIBOR − repo rate)

= −swap spread + [LIBOR − (LIBOR − 20 basis points)]

= 20 basis points − swap spread

2) The opposite of low swap spread where the swap spread was higher according to historical

data, LTCM would finance with short term identical asset and enter repo at LIBOR rate. The

cash flow generated would be:

(Fixed swap interest rate − treasury yield ) + (Reverse repo rate − LIBOR)

= Swap spread − 40 basis points.

LTCM also traded indices options. It believed current market volatility exceeded

prediction according to historical data. It used straddle which referred to long the call and put

option of an asset at the same exercise price and maturity.( Example see exhibit3) Writing a

strangle was another derivate that LTCM used often. It referred to speculations with

combinations of writing call and put options at once. It differed with straddle with out of the

money put and call with different exercise price. (Example see exhibit 4)

LTCM also traded pair stocks which identical stocks were short sold and longed at same

time with aiming convergence. In the case of trading Shell stock and Royal Dutch, LTCM lost a

bet of $286 million in part trades. LTCM also used pair trade in M&A assets: Long target firm

and short acquiring firm. But LTCM lost $150 million on Tellabs deal which deal was withdrew.

The fall began which macro conditions hit the market. Financial crisis of Asian market,

rubble devaluation, shrinking yield spread in bond…etc. All these factors had driven LTCM into

a position that it cannot deliver high return as previous years under its mechanism of investment.

( Details see exhibit 4) As a result, under the aid of Federal Reserve, LTCM was bailed out with

$3.5 billion.

Conclusion and Lessons

The case of LTCM, investors should realize high returns were not stable and any precious

hedge strategy relies on historical data was not steady as rocks. Three most warning lessons are:

1) Investors should perform due diligence no matter what investment firm has been

outperforming the market, and investors should be always notified with current risk

position that they are directly and indirectly involved with.

2) Deleverage requirement from regulations. It necessary for regulators to inform

investment firms to hand in a specific schedule of deleverage also copied to clients.

3) Investment firms should not always rely hedging strategy on spread of pair trade or call

and put options. There are macro-economic factors and other unseen industrial risk that

could not be hedge this way in any financial product.

Exhibit1

Exhibit 2

Exhibit 3

Exhibit 4

Exhibit 4