By Priya UpadhyayNeha JainLovleen BansalKeshab Chandra DashManas Tiwary

LONG TERM CAPITAL MANAGEMENT (LTCM) : A debacle that every stock market analyst should

understand…

About (LTCM)

• Founded in 1994, go bankrupt in 2000 • $1.28 trillion off-balance sheet worth of Asset Under

Management (AUM)

One of the largest (Star) hedge fund

at that time:

Stellar performance: 21%

first year, 43% second year, 41%

third year • 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)

Key people:

Due to the reputation of its managers, LTCM was able to raise impressive funds in very short period .

The Team and fundLTCM 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.

LTCM’s Failure Key Factors Taking highly leveraged positions

◦ Due to LTMC’s 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, LTMC’s Risk & Return Assumption

◦ Assume that risk premium (the difference in yield between risky and

risk- free 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….

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

And because of this Southeast Asia's export growth slowed dramatically in the spring of 1996, deteriorating their current account position

For the Southeast Asian nations , the higher U.S. dollar caused their own exports: expensive and less competitive in the global markets.

1990s, U.S. economy recovered from a recession, the U.S. Federal Reserve Bank under Alan Greenspan began to raise U.S. interest

rates to head off inflation.

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

Russian financial crisisTwo 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.

Oil prices

CRISIS

IMPACT ON LTCM

East Asian financial

crisis

In May and June

1998returns from the

fund were -6.42% and -

10.14% respectively,

reducing LTCM's capital

by $461 million.

Russian financial

crisis

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

LTCM major tradesSpread 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 tradeThey 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 year’s 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 maturity

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 company’s

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.

These trades involved finding securities that

were mispriced relative to one another, taking long positions in the

cheap ones and short positions in the rich

ones. For example- spread between “on-the-run”

treasury bonds and “off-the-run” treasury Bonds, i.e., 30-year bonds yielded 7.24%,

while 29 ½ year bonds yielded 7.36%.

Convergence trades

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.

LTCM would purchase the relatively low-priced, off-the-run security and simultaneously sell short the high-priced, on-the-run security.

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).

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.

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.

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 LTCM’s financing sources (e.g., lines of credit, unsecured debt, and equity base) were so

important

But if rates did not converge immediately, LTCM was prepared to finance these positions for extended periods.

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.

LTCM studied the relationships between yields and prices of numerous securities and their respective futures contracts to see if they were out of line.

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 LTCM’s 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 LTCM’s 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 LTCM’s financial models.

The more descriptive t-distribution should have been used by LTCM over the normal distribution.

By using the normal distribution, LTCM’s VAR calculations were quite low in comparison to the VAR that they would have calculated using the t-distribution 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 CollapseDuring LTCM’s 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 LTCM’s 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 LTCM’s 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 weeks of

September, LTCM's equity fell down from $2.3

billion at the start of the month to just $400 million by September 25.

With liabilities still over $100 billion, this translated to

an effective leverage ratio of

more than 250-to-1

BailoutOn 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.

The partners once had $1.9 billion of their own money invested in

LTCM, all of which was wiped out

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

AftermathBy mid‐December, 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 thinking about the business model could have prevented the

disaster.

VAR 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

company’s 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

the unexpected breakdown of historical correlations.

Those who look over the market such as the FED learned lessons

on the value of disclosure and transparency, and the danger of

over-generous extension of trading credit.

Thank You