Assignment On: What Was the Strategy of Long-Term Capital Management & Why They Failed? Prepared For:
Mr. Ashek Ishtiaq Haq Course Instructor Financial Engineering

Prepared By:
Md. Zahidul Alam 19th Batch MBA Program

Institute of Business Administration Jahangirnagar University
Submission Date: April 26, 2013

Long-Term Capital Management (LTCM) was a very large hedge fund ($126 billion in assets) that nearly collapsed in late 1998. It reached that size because of its reputated owners. The founder was a Salomon Brothers trader, John Meriwether, and the principal shareholders were Nobel prize-winning economists Myron Scholes and Robert Merton. These were all experts in investing in derivatives to make aboveaverage returns and outperform the market. Investors paid $10 million to get into the fund. They were not allowed to take the money out for three years, or even ask about the types of investments LTCM used. Despite these restrictions, investors clamored to get in, thanks to LTCM's spectacular annual returns of 42.8% in 1995 and 40.8% in 1996. This was after management took 27% off the top in fees. LTCM successfully hedged most of the risk from the 1997 Asian currency crisis, giving its investors a 17.1% return that year. Trading Strategies: LTCM used complex mathematical models to take advantage of fixed income arbitrage deals usually with U.S., Japanese, and European government bonds. Price differences between a 30 year treasury bond and a 29 and three quarter year old Treasury bond is very minimal. However, small discrepancies arise between the two bonds because of a difference in liquidity. By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting the more expensive, but more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond was issued. LTCM also attempted creating a splinter fund in 1996 called LTCM-X that would invest in even higher risk trades and also focus on Latin American markets. LTCM turned to UBS bank to invest in and write the warrant for this new spin-off company. With increased capital LTCM began to undertake more aggressive trading strategies. Although these trading strategies were market neutral, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998, LTCM had extremely large positions in areas such as merger arbitrage (betting whether mergers would be completed or not) and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 Vega, which had been in demand by companies seeking to essentially insure equities against future declines. As the profit margin was small, the fund needed to take highly-leveraged positions to make a significant profit. At the beginning of 1998, the net assets of firm were $129 billion (Equity of $4.72 billion, debt over $124.5 billion). LTCM maintained a debt to equity ratio of 25 to 1. It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options. Reasons of Failure: The primary reasons of failure of LTCM are given below:    Russia declared it was devaluing its currency and basically defaulting on its bonds, this event was beyond the regular range that LTCM had counted on. The U.S. stock market dropped 20%, while European markets fell 35%. Investors sought refuge in Treasury bonds, causing long-term interest rates to drop by more than a full point. LTCM's highly leveraged investments started to crumble. By the end of August 1998, it lost 50% of the value of its capital investments.

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In September, Bear Stearns dealt the final death blow. The investment bank, which managed all of LTCM's bond and derivatives settlements, called in a $500 million payment. Bear Stearns was afraid it would lose all of its investments, as LTCM had been out of compliance with its banking agreements for three months.

The Federal Reserve bailed out LTCM as it was near bankruptcy. Although an investment group led by Warren Buffett offered to buy out the shareholders for just $250 million and kept the fund running. Any banks and pension funds were invested in LTCM, its problems threatened to push most of them to near bankruptcy. Unfortunately, economic leaders did not learn from this mistake. The LTCM crisis was just an early warning symptom of the same disease that reoccurred with a vengeance in the 2008 global financial crisis. In this economic and financial crisis, only in U.S over 65 banks have become insolvent and have

been taken over by the FDIC since the beginning of 2008. Combined, these banks held over $55 billion in deposits, and the takeovers cost the federal government an estimated $17 billion