By
Priya Upadhyay
Neha Jain
Lovleen Bansal
Keshab Chandra
Dash
Manas Tiwary
LONG TERM CAPITAL MANAGEMENT (LTCM) :
A debacle that every stock market analyst should
About (LTCM)
One of the largest
(Star) hedge fund
at that time:
Founded in 1994, go bankrupt in 2000
$1.28 trillion off-balance sheet worth of Asset Under
Management (AUM)
Stellar
performance: 21%
first year, 43%
second year, 41%
third year
Key people:
John W. Meriwether (founder Famous Wall Street
Bond trader)
Myron S. Scholes and Robert C. Merton (shared 1997
Nobel Prize in Economic Sciences for discovery of
Black-Scholes model)
David Mullins (later become vice chairman of the
Federal Reserve)
Due to the reputation of its managers, LTCM was able to
raise impressive funds in very short period .
The Team and fund
LTCM aimed to provide high returns with low risk,
by leveraging low risk positions so much that the
overall volatility was equal to that of having an
unleveraged position in the U.S. stock exchange.
LTCM was free to operate in any market without
capital charges and only light reporting required by
the US Securities and Exchange Commission (SEC).
LTCM was able to finance their leveraging with repos
that had next-to-zero haircuts.
With all of this preferential treatment LTCM was able to
generate 43% and 41% respectively within their first
two years of operation and in that time LTCM had
accumulated $7 billion in capital.
LTCM usually charged management fees based on the
investment performance.
LTCMs Failure Key Factors
Taking
highly leveraged positions
Due to LTMCs reputation, most banks waive the margin requirement for
LTMC transaction of securities, taking long/short positions.
LTMC was able to take a more leveraged trading position
LTCM
Investment Strategy
Relative value Arbitrage based on Credit spread & Equity Volatility Seeks
to take advantage of price differentials between related financial
instruments, such as stocks and bonds, by simultaneously buying and
selling the different securities
Model
Risk, LTMCs Risk & Return Assumption
Assume that risk premium (the difference in yield between risky and riskfree securities) tended to revert to historical level.
Assume that volatility of equity options tended to revert to long-term
historical level.
East Asian financial crisis.
Asiaattractedalmosthalfofthetotalcapitalinflowto
developing countries.TheeconomiesofSoutheast
Asiainparticularmaintained 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
regionaleconomiesofThailand,Malaysia,Indonesia,
Singapore, and South Korea experienced high growth
rates, 812% GDP, in the late 1980s and early 1990s.
This achievement was widely acclaimed by financial
institutions including
theIMFandWorldBank,andwasknownaspartofthe
"Asian economic miracle".
Causes of East Asian crisis
In the mid-1990s, Two factors began to change their economic environment.
1990s,U.S. economyrecovered from a recession, theU.S.
FederalReserveBankunderAlanGreenspanbegantoraiseU.S. interest
rates to head off inflation.
For the SoutheastAsian nations, the higher U.S. dollar caused their own
exports: 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 accountposition
Russian financial crisis
Two external shocks, the Asian financial crisis that had
begun in 1997 and thefollowingdeclines
indemandfor(andthus priceof)crude oil and nonferrous
metals,impacted Russian foreign exchange reserves.
A political crisis came to a head in March when Russian
president Boris
YeltsinsuddenlydismissedPrimeMinisterViktorChernom
yrdinand 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.
Oil prices
CRISIS
IMPACT ON LTCM
East Asian
financial
crisis
Russian
financial
crisis
In May and June
The Russian Government defaulted on their
1998returns from the
Panicked investors sold Japanese and
fundwere -6.42% and10.14% respectively,
reducing LTCM's capital
by $461 million.
government bonds.
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 thebonds diverged.
By the end of August, the fund had lost $1.85
billion in capital
LTCM majorSpread
trades
Trades
RELATIVE-VALUE TRADES
Paired Trades
Swaps
Pooled Mortgage Market
Investments
Yield Curve Trades
CONVERGENCE TRADES
Directional Trades
OUTRIGHT EQUITY
PURCHASES
RISK ARBITRAGE
BUYING AND SELLING
VOLATILITY
Relative value trade
They buy the security
that they believe is
underpriced and sell the
security that they believe
is overpriced which allows
them to profit from the
relative movements of
two particular securities.
For example, assume that there are two
types of securities that are very similar.
Each security will pay $100 in one years
time. security A trades at $100 security B
trades for only $98.
Buy security B and sell short security A
He is simply betting that the prices of the
two securities must eventually converge till
Paired trade
A paired trade involves an
arbitrage between two assets
whose prices (yields) usually
move in tandem but occasionally
diverge.
Often, they involve shares of
companies in the same industry,
but they can also involve shares
of the same company, which are
listed simultaneously on two or
more exchanges
Due to factors such as
differences in liquidity, taxes,
expectations, or regulations,
these shares do not always trade
at equivalent prices.
Italian swap spread in
1994
Swaps are transactions whose notional values (i.e., the face
value of the contracts) are never seen on a companys
balance sheet.
Rather, these iceberg-sized assets and liabilities are
recorded off-balance sheet and reported in the footnotes of
companies financial statements.
Long-Term felt that investors were irrationally bearish on a
type of Italian treasury bond known as a BTP, Italian
treasury bonds actually provided a higher yield than Italian
corporate swaps of comparable duration
In essence, they were long Italian treasuries and short
Italian swaps.
The net effect of these transactions, then was for LTCM to
be receiving Italian treasury coupon payments in exchange
for paying the fixed swap rate.
Convergence
trades
These
trades involved
finding securities that
were mispriced relative
to one another, taking
long positions in the
cheap ones and short
positions
the rich
For in
examplespread
ones. on-the-run
between
treasury bonds and off-therun treasury Bonds, i.e., 30year bonds yielded 7.24%,
while 29 year bonds
LTCM studied the relationships between yields and prices of numerous securities and their respective futures
contracts to see if they were out of line.
When they were, the company bought the relatively underpriced instrument and sold the relatively overpriced
instrument. If the rates converged rapidly and immediately, LTCM would close out these positions prior to
maturity, book the profits, and move on to a new deal.
But if rates did not converge immediately, LTCM was prepared to finance these positions for extended periods.
Earning profits was almost a sure thing, as long as LTCM could wait until the forces of convergence took hold. It
was for this reason that LTCMs financing sources (e.g., lines of credit, unsecured debt, and equity base) were so
important
An example of a convergence trade that LTCM used to profit from slight price misalignments involved on-the-run
and off-the-run U.S. Treasury securities.
Price discrepancies in this market occur because on-the-run securities are newly issued and have relatively more
active markets than off-the-run securities, which are seasoned.
Because of the relatively higher demand, the price of a newly issued Treasury bond with a 30-year maturity
might be high compared to an off-the-run bond that was issued six months ago (i.e., with 29.5 years to maturity).
LTCM would purchase the relatively low-priced, off-the-run security and simultaneously sell short the high-priced,
on-the-run security.
After a few days, the on-the-run securities would become seasoned and their prices would converge to the
already seasoned securities, thereby earning LTCM a profit.
There were four main types of
trade:
Convergence among U.S., Japan, and
European sovereign bonds
Convergence among European sovereign
bonds
Convergence between on-the-run and
off- the-run U.S. government bonds
Long positions in emerging markets
sovereigns, hedged back to dollars.
Directional trades- These trades involve
taking positions based on the direction an
investor expects absolute prices or yields
to move.
Risk arbitrage Risk arbitrageurs take positions in companies
that are being acquired, and they often take
simultaneous positions in the companies that are
doing the acquiring.
Buying and selling volatility
If the market price of an option had an implied (i.e., embedded)
future volatility that was lower than LTCM felt it should be, they
would purchase the underpriced option, with the expectation that
its price would rise.
In general, LTCM analysts believed that markets tend to overreact
to bad news; so, there were usually opportunities to profit when
turbulence was at its greatest.
The Risks
The main risk measure to explain the risk associated with
such a portfolio is the Value at Risk measure.
The Value at Risk has been heavily blamed for LTCMs
failure. The 1-day VAR is the expected loss that one could
expect to lose over one day, under normal market
conditions.
The VAR risk measure helps a portfolio manager to
determine how much capital they need to set aside in order
to survive any misfortunes they might encounter under
normal market operating conditions.
As a basis for calculating the amount of equity capital that
is needed to be set aside, extreme care must be taken
when choosing the parameters.
For LTCM it seemed that their positions were not reduced
relative to the capital reduction, so this increased the
leverage of the portfolio.
The Models
The well renowned Black-Scholes model formed the base of LTCMs financial
modeling strategy. This model is highly reliant on historical data in order to
estimate the parameters.
This Black-Scholes model chooses to explain the white noise inherent in the
stock market by using the Wiener process that is bases on the Normal
distribution.
The VAR calculations that were used by LTCM were also based on the Normal
distribution. This assumption of Normal distribution proved to be a large flaw
in LTCMs financial models.
The more descriptive t-distribution should have been used by LTCM over the
normal distribution.
By using the normal distribution, LTCMs VAR calculations were quite low in
comparison to the VAR that they would have calculated using the tdistribution thus they were not holding sufficient collateral capital in order to
safely operate under normal market conditions.
Mistaken assumptions
They were not
fully aware of
market price
dynamics.
Over-reliance
on var
methods did
not allow it to
anticipate
how the
markets
would
behave.
Returns were
negatively
correlated
with liquidity.
Positions were
simply too big
for some of
the markets it
traded in.
The Collapse
During LTCMs prime they had the
confidence, technological edge and
high leveraging that helped them
to achieve the exorbitant profits
that made them so prominent in
the investment world.
They began with a record $1.25
Billion start-up capital and were
earning profits of about 30%-60%
from 1994 until 1997. LTCM enjoyed
such headlines as The best
financial faculty in the world
Institutional Investor.
In 1997, Robert Merton and Myron
Scholes were awarded the Nobel
Memorial Prize in Economic
Sciences for their work on stock
options.
During 1997 LTCMs profits were only
17%, due to other companies spotting
the same arbitrage that LTCM did and
were also implementing similar
strategies.
So in 1997 LTCM decided to return $2.7
billion of capital back to its investors,
while at the same time they
maintained their total assets at $130
billion.
By shrinking their capital base, LTCM
were able to increase their leverage
ratio back up to 28. This decrease in
capital while maintaining high total
assets increased LTCMs risks.
LTCM should of reduced their positions
relative to their capital reduction in
order not to incur any additional risk.
Unexpected and Extreme
events
August
1998, Russia defaults on it debts, Russia Interest Rate soaring
200%, Crushing Value of Ruble
Brazil
devalued its currency
Increase interest rate, risk premium and market volatility unexpectedly
LTCM
lost 44% of its capital in 1 month due to Cash flow crisis
Force
to liquidate position to meet margin calls due to sharp divergence
of asset prices.
Prices
in Relative value arbitrage strategy can diverge and create
temporary losses before they ultimately converge.
If
LTCM have enough funds to withstand the Cash Flow Crisis, The hedge
fund will ultimately gain profit in the long-term (when prices converge)
What LTCM did?
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 was
"long" in Shell and the other half was "short" in
Royal Dutch.
LTCM was essentially betting that the share prices
of Royal Dutch and Shell would converge. This
might 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.
Key facts
LTCM lost $286
million in equity pairs
trading and more
than half of this loss
is accounted for by
the Royal Dutch Shell
trade.
In the first three
With liabilities still weeks of September,
over $100 billion, this
LTCM's equity fell
translated to an
down from $2.3
effective leverage
billion at the start of
ratio of more than
the month to just
250-to-1
$400 million by
September 25.
Bailout
On September 23, 1998, 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.
Seeing no options left, the Federal Reserve
Bank of New York organized a bailout of
$3.625 billion.
The principal negotiator for LTCM was
general counsel James G. Rickards
Contributions
The contributions from the various institutions were as follows:
i.
$300 million: Bankers Trust, Barclays, Chase, Credit Suisse First
Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P
Morgan, Morgan Stanley, Salomon Smith Barney, UBS
ii.
$125 million: Societe Generale
iii.
$100 million: Paribas, Credit Agricole
iv.
No Participation: Bear Stearns and Lehman Brothers
. In
return, the participating banks got a 90% share in the fund and
a promise that a supervisory board would be established.
. LTCM's
partners received a 10% stake, still worth about $400
million, but this money was completely consumed by their debts.
Losses Occurred
The total losses were found to be $4.6 billion. The losses in
the major investment categories were (ordered by magnitude):
$1.6 billion in swaps
$1.3 billion in equity volatility
$430 million in Russia and other emerging markets
$371 million in directional trades in developed countries
$286 million in Dual-listed company pairs (such as VW,
Shell)
$215 million in yield curve arbitrage
$203 million in S&P 500 stocks
$100 million in junk bond arbitrage
No substantial losses in merger arbitrage
Aftermath
By midDecember, 1998 the fund was reporting
a profit of $400 million, net of fees to LTCM
partners and staff.
By June 30, 1999 the fund was up 14.1%, net of
fees, from the previous September.
Meriwether's plan, approved by the consortium,
was to redeem the fund, then valued at around
$4.7 billion, and to start another fund
concentrating on buyouts and mortgages.
On July 6, 1999,LTCM repaid $300 million to its
original investors who had a residual stake in
the fund of around 9%.
It also paid out $1 billion to the 14 consortium
members
Lessons to be learnt
An
organization is only as strong as its weakest link.
Strategic
VAR
thinking about the business model could have prevented the disaster.
has proved to be unreliable as a measure of risk over long time periods or
under abnormal market conditions. The danger posed by exceptional market
shocks can be captured only by means of supplemental methodologies.
The
catastrophic losses were caused by systemic risks that LTCM had not
foreseen in its business model. The failure of the hedge fund is a classic
example of model risk in the financial services industry.
LTCM
provides a reminder of the notion that there is no such thing as a risk-free
arbitrage.
Effective
management controls could have prevented the disaster.
LTCM failed because both its trading models and its risk
management models failed to anticipate the cycle of losses that
could occur during an extreme crisis when volatilities rose
dramatically, correlations between markets and instruments
became closer to 1, and liquidity dried up.
Risk control at LTCM relied on a VAR model. However, the
companys risk modeling was inappropriate and let it down.
The theories of Merton and Scholes took a public beating. In its
annual reports, Merrill Lynch observed that mathematical risk
models may provide a greater sense of security than warranted;
therefore, reliance on these models should be limited.
LTCM journey
Conclusion
By the year 2000, the LTCM fund had been liquidated and the
theories of Merton and Scholes had taken a serious beating.
After helping with the unwinding of LTCM, Meriwether and his
group had launched JWM partners.
Together they were able to raise $250 million in starting capital
for their new fund that would continue with many of their original
strategies from LTCM but using a lot less leveraging.
During the credit crisis JWM experienced losses of 44% during the
period of 2007 to 2009. As a result of such heavy losses, JWM
Hedge Fund was shut down in July of 2009.
The LTCM fiasco contains lessons for traders on model risk and
Thank You
