Baroncini Gianni
Meloni Valerio
Santangelo Giusj
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The history;
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Brief description of the case;
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Risk factors explaining the case;
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Lessons to be learnt (strategy / control /
regulation).
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1994-Foundation of Long-Term Capital
Management by John Meriwether. Initial equity of
$1,3 billion.
2 years of returns
running close to 40%
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1997-Capitalization of $7 billion. Return has
dropped to 27%. $2,7 billion returned back to
investors.
More aggressive
trading strategies
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Early 1998
LTCM's portfolio
Over $100 billion
Net asset value
$4 billion
Swaps position
$1.25 trillion notional
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1994-1997. LTCM's strategy was to make
convergence trades, finding securities that were
mispriced relative to one another, taking long
positions in the cheap ones and short positions in
the rich ones.
The main types of trade were:
1-Convergence among U.S., Japan, and European sovereign bonds;
2-Convergence between “on-the-run” and “off-the-run” U.S.
government bonds(30 year treasury bond and a 29 and three quarter year
old treasury bond)
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1998- More aggressive strategies:
-S&P 500 options;
-Interest rate swaps(notional value of $1.25 trillion);
-Long positions in emerging markets sovereigns, hedged back to
dollars;
-other derivatives such as equity options.
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the fund needed to take highly-leveraged positions to make a
significant profit;
the firm had equity of $4.72 billion and had borrowed over $124.5
billion with assets of around $129 billion;
debt to equity ratio = 25 / 1.
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The company used complex mathematical models to
take advantage of fixed income arbitrage;
Relative value trading;
It was a game, in that LTCM was unregulated, free to
operate in any market;
To make high return on capital, high leverage had to be
applied;
There was also a big difference in liquidity between long
and short positions in which it entered.
17 August 1998: devaluation of the rouble
flight to quality
1 September 1998: special terms
22 September 1998: leverage is even higher
23 September 1998: consortium of leading investment and commercial
banks
Fourth quarter 1998: substantial write-off as a result of losses
1. Russian Sovereign Default
2. Flight to liquidity
As Russia's troubles became deeper and deeper, fixedincome portfolio managers began to shift their assets
to more liquid assets
Flight to liquidity
What LTCM had failed to account for is that a substantial portion of its
balance sheet was exposed to a general change in the "price" of liquidity
There is an unhedged exposure to a
single risk factor.
Trade
Volatility
Default
Illiquidity
Long Interest Rate Swap
Yes
Yes
Yes
Short Equity Options
Yes
Long off the run/Short on the run treasuries Yes
Yes
Long Mortgage
Yes
Yes
Long Sovereign Debt
Yes
Yes
Yes
The Flight to liquidity is a common phenomenon in capital markets
crises that it should be built into risk models, either by introducing a
new risk factor — liquidity — or by including a flight to liquidity in the
stress testing
If LTCM have classified its positions as illiquid (referred to long positions in large part) or
liquid (the most of its short positions), it would notice that the notional exposure to the
liquidity factor is equal to twice its total balance sheet.
Financial models are subject to model risk and parameter
risk, and should therefore be stress-tested and tempered
with judgement.
According to the complex mathematical models used by LTCM, the positions were low risk.
Judgement tells us that the key assumption that the models depended on was the high
correlation between the long and short positions. Certainly, recent history suggested that
correlations between corporate bonds of different credit quality would move together (a
correlation of between 90-95% over a 2-year horizon).
During Russia's crisis, however, this correlation dropped to 80%. Stress-testing against this
lower correlation might have led LTCM to assume less leverage in taking this bet.
Exploit deviations in market value from fair value generate excellent riskadjusted returns, but only if held for a long time. Unfortunately the only real
source of capital that is patient enough to take fluctuations in market values,
especially through crises, is equity capital.
We can use Leverage, but not so much
LTCM depended on exploiting deviations in market value from fair value. And depended on
"patient capital" - shareholders and lenders who believed that what mattered was fair value and
not market value. Lenders lost their patience precisely when the funds need them to keep it — in
times of market crisis
A systematic risk management process have to be used to
discover common linkages ex ante and report or reduce the risk
concentration.
Many of the large dealer banks are exposed to a Russian crisis across many different businesses,
and they only became aware of the commonality of these exposures after the LTCM crisis.