Table of ContentsLong Term Capital Management LP A Case StudyHedge Funds and the Uniqueness of LTCMInvestment StrategiesWhat Went WrongThe LTCM Collapse and Possible CausesHow the Fed saved LTCM and why it went bankruptInternational Significance of LTCMLessons LearnedSummaryLong Term Capital Management LP A Case Study Rarely, if ever, has a single company had such a tremendous impact on the international economy as Long Term Capital Management LP (LTCM ). This report describes the company itself and its investment strategies, with particular attention paid to its international influence and importance. LTCM's activities in the financial world ultimately caused a near-collapse of the entire international financial system. In fact, if the Federal Reserve Bank of New York (FRBNY) had not stepped in to coordinate a major buyout of LTCM after its bankruptcy, the entire financial system could have been seriously threatened. Say no to plagiarism. Get a tailor-made essay on “Why Violent Video Games Should Not Be Banned”? Get an original essay Created as a particularly large hedge fund and staffed by Ph.D. established Wall Street economists and bond traders, LTCM is a very interesting case, as well as an extremely volatile and large fund. Founded in part by Nobel laureates Robert Merton and Myron Scholes, LTCM based its investment strategies on mathematical models developed by Scholes, Merton and Fischer Black. The model itself, commonly known as the Black-Scholes option pricing model, is famous for two major ideas about economic thinking. First, the model determines how to eliminate risk as a variable in the options pricing equation. This was achieved through the second major idea, namely the idea of ​​using continuous time for options pricing, as opposed to second-by-second timing, a crucial element that Robert Merton borrowed from a Japanese options specialist. rockets named Ito. Figuring out how to de-risk large-scale investments is obviously a major breakthrough that puts greed in people's eyes and makes major investment players fight for the chance to invest where the model will be d first used in practice. Incorporating the concept of continuous time into the pricing model eliminated the problem of the price of an appropriate option being obsolete at the time of its calculation. As champions of these powerful tools, Merton and Scholes decided to play in the financial markets that had already been transformed by their ideas. The Black-Scholes model is as follows: Value of a call option = P0N(d1) - X [N(d2)]eKRFtWhere Po = the current price of a stock ) of the optiont = time remaining until the option expires KRF = continuously compounded risk-free interest rate = the natural antilog of 1.00 or 2.71828N(d) = the probability that a A standardized, normally distributed random variable has a value less than or equal to d, essentially hedge ratios.1The Black-Scholes pricing model can adjust the value of options to reflect continuous changes in stock prices. Black, Scholes and Merton seemed to have achieved a breakthrough that could finally bring perfect efficiency to global markets. John Meriwether, a wealthy and famous Wall Street bond trader from Soloman Brothers Inc., also played a vital role in the company's history. Meriwether left Soloman after seeing his name too closely associated with a bond auction fraud scandal orchestrated by one of his colleagues. Meriwether,an old friend of Scholes, brought his expertise in bond markets and bond futures to the company as a senior executive. Also a co-founder, Meriwether brought with him from Soloman several of his former colleagues, who had also left Soloman after the bond fraud scandal in 1992. Hedge funds and the uniqueness of the hedge fund LTCMA is organized much like a hedge fund mutual investment accounts (both are private and mutual investment accounts), but with some significant differences. Legally, a hedgeThis fund is distinguished by the fact that it limits the number of investors to 500 per fund. In addition, to be able to invest in American hedge funds, a minimum capital of US$5 million is required for individuals and US$25 million for institutional investors. In the case of LTCM, only individuals and institutions sought by the fund's partners were able to invest in the company. Other elements that distinguish hedge funds from mutual funds include: Hedge fund managers have almost complete autonomy in determining which assets to hold, and are not at all limited in the types of assets they can hold. they can hold. Hedge funds are allowed to engage in short selling. Hedge funds can use leverage to increase funding levels as well as risk and return. Hedge funds can limit the amount of cash injected into and withdrawn from the fund by its investors. 2LTCM has therefore been able to engage in virtually any investment strategy chosen by its managers. The fund's founders were not subject to any rules regarding the types of assets they could hold in the fund, including derivative securities, margins, bond futures and currencies. Fund managers could also short assets at will. Many believe that excessive use of leverage has become a serious problem at LTCM. Proponents of this theory even believe that excessive leverage caused the funds to collapse. The term hedge fund is basically a misnomer because it sounds like a hedge, but it is almost the opposite idea. Hedging refers to investment strategies that reduce the risk associated with owning financial assets, typically through the use of derivatives. A hedge fund is a large, privatized pool of investment money that is normally invested in relatively high-risk securities. LTCM was not your average hedge fund. It primarily used arbitrage techniques and strategies between bonds and bond futures derived from the mathematical information provided by the Black-Scholes model which allowed them to continuously monitor the true value of the derivative securities. The sheer scale of their investments also set them apart. Starting with approximately $4 billion in initial capital, the fund quickly grew to a peak position of $1.2 trillion. The institution's risk management practices involved attempting to eliminate risk by continually adjusting their holdings to react to constantly changing market prices. When LTCM nearly collapsed, the partners themselves lost US$1.9 billion, out of the US$4.4 billion lost by the fund (see loss pie chart). . Contrary to myth, not all hedge funds are highly leveraged. LTCM was often in debt to the tune of around thirty times its capital and the institution borrowed mainly from the same companies that had invested in it. Many companies have invested inLTCM based on the premise that LTCM's strategies were foolproof. 3LTCM essentially engaged in types of transactions that no one else would think of and, because of this, it quickly became the company to watch and imitate for many fund managers. . In fact, some believe this mirroring of investment strategies contributed to its downfall. LTCM was primarily involved in trading in bond markets where pricing is still somewhat inefficient.4 The institution was betting on interest rate differentials between corporate and government bonds. , and on market volatility. LTCM used the Black-Scholes pricing model and other cutting-edge pricing techniques to determine which bonds were undervalued and which were overvalued according to these mathematical models, then placed its bets accordingly. The company monitored the differences between government bonds and corporate bonds, and when the difference was thought to be at its widest, it bought relatively cheap corporate bonds and shorted the government bonds. 'State relatively expensive. When the gap between the two narrows, the fund would profit, but if the gap widens further, the fund would suffer a loss. However, in the case of LTCM, the sheer scale of investments made by the company could often move rates in the direction LTCM desired.5 One particular trade that persisted in LTCM and exemplified their overall trading strategies was a bet on the convergence of yield gaps between French companies. bonds (OAT) and German bonds (bunds). According to parties associated with LTCM, the fund engaged in dozens of spot and forward transactions, interest rate swaps, foreign exchange forward contracts and options. . . to build a position of $10 billion6. When the spread between OATs and bunds increased to 60 basis points in the futures market, LTCM decided to double its position. Another competing arbitrageur says the deal was actually just one step in an even more complex convergence bet, which included hedged positions in Spanish peseta and Italian lira bonds.7 LTCM would have made about a third of its profits from an Italian tax arbitration agreement from which many other arbitrageurs also profited.8 LTCM distinguished itself in its trading strategies mainly by two things; the thoroughness of its preparations for the transactions it carried out and the propensity of the funds to invest unusually large sums of money in profitable transactions. With all of these factors working in the company's favor, it's hard to see how LTCM could fail so miserably and suddenly. What Went WrongIn September 1998, LTCM found itself in a crisis situation. It appears that the institution underestimated the consequences that short-term liquidity problems could have.9 Shortly after falling into insolvency, the Federal Reserve Bank of New York saved the company from bankruptcy. Collapse of LTCMs and possible causes It is impossible to determine with certainty specific factors that caused the collapse and near disappearance of LTCMs. Many claim that the excessive leverage used by the fund (approximately 30 times their capital) magnified their losses disproportionately when they began to lose liquidity.10 Additionally, LTCM relied on a model of academic pricing which ultimately turned out to be a model applicable only in normal times. market conditions, and not in extreme conditions. The increaseRisk and theoretical economics have certainly played a role in the virtual disappearance of LTCM. The global financial crisis of September 1998 also contributed to this situation. There were probably two compelling pieces of evidence for this particular global financial anomaly. The first was the monetary reform in Thailand and the subsequent devaluation of the national currency. The second was the Russian government's default on its debts, which dried up liquidity associated with the ruble and Russian financial assets. In mid-1998, Thailand moved from a fixed exchange rate system to a floating exchange rate system. When the demand they expected for their assets failed to materialize, the value of their currency collapsed. This led to the collapse of a few major Asian banks that had significant stakes in Thailand, resulting in a general and rapid economic downturn in Asian countries in which LTCM had outstanding interest rate options. Around the same time, Russia, another country. with which LTCM had exceptional foreign exchange bets, was in the midst of an economic collapse of its own. The social revolt against the communist government has put a stranglehold on discretion and control over Russia's fiscal policy. When the Russian government defaulted on its debts, the market reaction was catastrophic and LTCM, among others, lost all its interests in Russia. The one in a million chance of these types of events occurring simultaneously has actually materialized. LTCM made itself particularly vulnerable to losses in this type of situation. When a hedge fund arbitrages between the currency bonds of several major economic countries and the futures contracts on those bonds, a major collapse in one of those countries can trigger a domino effect with the potential to destroy all players involved, essentially by drying up the country's liquidity. those active. For example, if LTCM is betting on an interest rate increase in Japan, and it is, LTCM will assume it is in the money on that trade. They will use the money they have not yet received to underwrite similar interest rate bets with, say, Germany. Then, if Japan defaults on the money it owes LTCM, the German options it obtained will also dry up. The German institution with which LTCM did business would then also find itself short of the money it hoped to receive from LTCM. It is then clear that the supply and demand for liquidity of financial assets are the basis of LTCM's investment strategies. LTCM has relied on the global diversity of its positions, assuming that global diversification negates any risk.11 But the correlation between global markets tends to amplify. rising in times of difficulty, reflecting economic linkages between markets and social factors. LTCM representatives believe that the company's near collapse was the result of two phases of external panic.12 First, Wall Street firms began to doubt LTCM. Social panic followed Wall Street's corporate market panic. Rumors spread that LTCM had weakened. LTCM believes that other companies have taken advantage of their weakness to strengthen themselves. Wall Street firms began to replicate LTCM's investment strategies, which weakened LTCM's position in the market. The institution was weak and had a huge market share. Of course, other companies would like to destroy LTCM to strengthen their own positions. Another suggested contributor to LTCM's near collapse is the following. A bigMany of the positions in the LTCM portfolio depended on a narrowing of the spread between two related securities (i.e., hedging two securities). This means that investors take a long position (i.e. buy) the higher yielding security and take a short position (i.e. sell) the lower yielding security hoping that l The gap will narrow. When high leverage is used, the spread can be extremely profitable if the spread relationship remains constant or narrows. In fact, betting on market volatility in this way leads to a no-win situation. A company bets on market volatility and will make a profit when it does, but buying derivative securities such as volatility swaps and straddles is a zero-sum game. When the company makes a profit, its counterparty loses, making the company less likely to get its money back because the loss could bankrupt the counterparty. This is called counterparty risk, and LTCM was certainly affected when liquidity in the Russian and Asian markets dried up. If liquidity had been available, LTCM could have survived. Therefore, the problem was not necessarily the leverage used by LTCM; the lack of market liquidity could have been a more direct cause of the fund failure. Other companies with similar activities were trying to reduce these gaps at the same time. This caused spreads to widen, leading to large losses for highly leveraged banks and hedge funds such as LTCM.13LTCM lost money at unprecedented rates. After generating a return above 40% for three consecutive years, the fund lost US$500 million for two consecutive days.14 Very few, if any, companies have the liquidity to avoid being overwhelmed by a loss. of one billion US dollars in a 48-hour period. LTCM became insolvent very suddenly and the value of the portfolios continued to fall due to psychological market reactions (i.e. loss of confidence, changes in credit ratings). Over a six-week period in August/September 1998, LTCM lost approximately US$4.4 billion and would have declared bankruptcy without the intervention of the FRBNY. How the Fed Saved LTCM and Why It Did It The FRBNY saved LTCM from bankruptcy by consolidating fourteen U.S. investment banks and securities firms collectively bailed out LTCM for $3.625 billion in September 1998. The company still exists , and John Meriwether is now involved in gradually repaying many of the original investors' funds for what Myron Scholes calls a no-fault bankruptcy. 15Why did the Fed go to such lengths to save this particular company? What did she have to gain by doing this? What was he trying to accomplish or avoid? The answer is that after carrying out an audit of LTCM's accounting records, the FRBNY recognized the strategic importance of the international financial situation of this company. The FRBNY feared that the default of the LTCMs would pose a great danger to the entire international financial system due to the size, nature and complexity of the wealth they had spread around the world. The international significance of LTCM's investments is discussed in the following section. LTCM's International Significance LTCM had spread its investment position across 75 different countries, in order to avoid concentrating risks in any one area.16 This ultimately worked to the detriment of the funds, as its position nearly created an international catastrophe. However, this also benefited LTCMs, as the Fed did not..