LONG TERM CAPITAL MANAGEMENT L.P. A CASE STUDY Rarely if ever has a single firm had as tremendous an impact on international economics as Long Term Capital Management L. P. (LTCM). This report describes the company itself and its investment strategies, with particular attention paid to its international influence and importance.
LTCMs activities in the financial world ultimately caused a near-collapse in the entire international financial system. In fact, had the Federal Reserve Bank of New York (FRBNY) not intervened to coordinate a major buyout of LTCM after it sunk into insolvency, the entire financial system could have been seriously jeopardized. Company Profile Set up as a particularly large hedge fund, and comprised of Ph.D. economists and established Wall Street bond traders, LTCM is a very interesting case, as well as an extremely volatile and important fund. ? Key Members and Their Backgrounds Founded in part by Nobel laureates Robert Merton and Myron Scholes, LTCM based its investment strategies on the mathematical models developed by Scholes, Merton, and Fischer Black. The model itself, commonly known as the “Black-Scholes Options Pricing Model”, is famous for two major insights into economic thought. First, the model determines how to eliminate risk as a variable in the option-pricing equation.
This was accomplished as a result of the second major insight, which was the idea of using continuous time for option pricing as opposed to second-by-second timing, a most crucial element that Robert Merton borrowed from a Japanese rocket scientist named Ito. Discovering how risk can be eliminated from large-scale investing is obviously an enormous break-through that puts greed in peoples eyes and gets major investment players fighting for the chance to invest where the model will first be used in practice. Integrating the notion of continuous time into the pricing model eliminated the problem of an appropriate option price being out-of-date by the time it was calculated. As champions of these powerful tools, Merton and Scholes decided to play the very financial markets that had already been transformed by their insights. The Black-Scholes model is: Value of a call option = P0N(d1) – X [N(d2)] eKRFt Where Po = the current price of a stock X = the exercise (strike) price on the option t = time remaining until expiration of the option KRF = continually compounded risk-free interest rate e = the natural antilog of 1.00 or 2.71828 N(d) = the probability that a standardized, normally distributed random variable will have a value less than or equal to d, essentially the hedge ratios.1 The Black-Scholes pricing model can adjust the value of options to reflect continuously changing stock prices.
Black, Scholes and Merton appeared to have made the break-through that could finally bring perfect efficiency to the worlds markets. John Meriwether, a wealthy and famous Wall Street bond trader from Soloman Brothers Inc., also played an integral role in the history of the firm. Meriwether left Soloman after having 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 firm as its top 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 LTCM A hedge fund is organized much like a mutual fund (both are private, pooled investment accounts), but with some significant differences. Legally, a hedge fund is distinguishable by the fact that it limits the number of investors to 500 per fund. Also, to qualify to invest in American hedge funds requires a minimum capital amount of US$5 million for individuals, and US$25 million for institutional investors. In the case of LTCM, only those individuals and institutions that the funds partners sought out were able to invest in the firm. Other things that distinguish hedge from mutual funds are: ? Hedge fund managers have almost complete autonomy in determining what assets to hold, and are not at all limited in what types of assets they can hold.
? Hedge funds are allowed to engage in short selling. ? Hedge funds may use leverage to increase levels of funding and of risk and return. ? Hedge funds can limit the amount cash injected into and withdrawn from the fund by its investors.2 LTCM was therefore able to engage in virtually any investment strategies its managers chose. The funds 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. The funds managers could also short-sell assets at will. Many believe the excessive use of leverage became a serious problem at LTCM. Holders of this theory even believe that excessive leverage caused the funds near collapse.
The term hedge fund is essentially a misnomer, as it sounds like “hedging” but is almost the opposite idea. Hedging refers to investment strategies that reduce the risk associated with owning financial assets, usually by 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 the average hedge fund. It primarily used techniques and strategies of arbitraging between bonds and bond futures derived from the mathematical insights provided by the Black-Scholes model that allowed them to continually monitor the “true” value of derivative securities. The sheer size of their investments distinguished them as well.
Starting with about US$4 billion of initial capital, the fund rapidly grew to obtain a peak position of US$1.2 trillion. The institutions risk-management practices consisted of attempting to eliminate risk by continually adjusting their holdings to react to continually changing market prices. When LTCM nearly collapsed, the partners themselves personally lost US$1.9 billion, of the total US$4.4 billion that the fund lost (see Exhibit A Pie Chart of Losses). ? Investment Strategies Using arbitrage techniques that appeared infallible, LTCM used excessive leverage to magnify its earnings. Contrary to the myth, hedge funds are not all highly leveraged. LTCM was often leveraged at about thirty times its capital and the institution was primarily borrowing from the same companies that had invested in it.
Many companies invested in LTCM under the assumption that LTCMs strategies were infallible.3 LTCM essentially engaged in the types of trades that no one else would think of, and for this reason, they quickly became the “firm-to-watch” and emulate for many fund managers. In fact, some believe that this mirroring of investment strategies contributed to its downfall. LTCM was chiefly involved with making trades in bond markets where price-determination is still somewhat inefficient.4 The institution placed bets on interest rate spreads between corporate bonds and government bonds, and on the volatility of markets. LTCM used the Black-Scholes pricing model and other state-of-the-art price-determination techniques to see which bonds were undervalued and which were overvalued according to those mathematical models, and then placed their bets accordingly. The firm watched differences between government bonds and corporate bonds, and when the difference was believed to be at its peak, it would buy into the relatively cheap corporate bonds and short sell the relatively expensive government bonds.
When the gap between the two tightened, the fund would profit, but if the gap spread further, the fund would sustain a loss. However, in LTCMs case, the sheer size of the investments the company was making could often drive the rates in LTCMs desired direction.5 One particular trade that persisted in LTCM and exemplified their overall trading strategies was a bet on the convergence of yield spreads between French bonds (OATs) and German bonds (bunds). According to parties associated with LTCM, the fund “engaged in dozens of cash and futures trades, interest rate swaps, currency forwards and options . . . to build a US$10 billion position.”6 When the spread between the OATs and the bunds went to 60 basis points in the forward market, LTCM decided to double its position. Another competing arbitrageur says that this deal was actually “only one leg of an even more complex convergence bet, which included hedged positions in Spanish peseta and Italian lira bonds.”7 LTCM reportedly derived approximately one third of its profits from an Italian tax-driven arbitrage deal of which many other arbitrageurs were also taking advantage.8 LTCM was distinguished in its trading strategies primarily by two things; the thoroughness of its preparations for the trades it made, and the funds propensity to invest abnormally large amounts of cash in profitable deals.
With all of these factors working in the companys favor, it is difficult to see how LTCM could fail so miserably and suddenly. What Went Wrong In September 1998, LTCM found itself in a crisis situation. It appears that the institution had underestimated the consequences that short-term liquidity problems could pose.9 Shortly after falling into insolvency, the Federal Reserve Bank of New York rescued the company from bankruptcy. ? LTCMs Collapse and Possible Causes It is impossible to determine for certain what specific factors caused LTCMs collapse and near-demise. Many say that the excessive amount of leverage the fund was using (about 30 times their capital) magnified their losses inordinately when they began losing cash.10 Also, LTCM relied on an academic pricing model that ultimately proved to be a model only applicable during “normal” market conditions, and not in extreme conditions. Magnified risk and theoretical economics certainly played a role in LTCMs near demise.
Another contributor was the global financial crisis in September 1998. There were two likely “smoking guns” of that particular global financial anomaly. The first was the currency reform in Thailand and the ensuing devaluation of the nations currency. The second was the Russian government defaulting on their debts, which dried up the liquidity associated with the ruble and Russian financial assets. In mid-1998, Thailand switched from a fixed exchange rate system to a floating rate system. When the demand they had expected for their assets did not materialize, their currency value plummeted. This led to the collapse of a few large Asian banks that had significant stake in Thailand, which led to a general, rapid economic downturn in the Asian countries in which LTCM had outstanding interest rate options.
Around the same time period, Russia, another country with which LTCM had outstanding currency bets, was in the midst of an economic collapse of their own. Social revolt against the communist government put a stranglehold on Russias fiscal policy discretion and control. When the Russian Government defaulted on their debts, the markets reaction was expectedly catastrophic, and LTCM among others lost all their interests in Russia. The million-to-one chance that these types of events would happen simultaneously actually materialized. LTCM had left itself particularly susceptible to losses in this type of situation. When a hedge fund arbitrages between the currency bonds of several major economic nations and futures on those bonds, a major collapse in one of those nations can begin a domino effect with the potential of destroying all the players involved, essentially by drying up the liquidity in those assets.
For example, if LTCM is betting on interest rates in Japan to increase, and they do, LTCM will assume they are “in the money” on that deal. They will use the cash they have not yet received to secure similar interest rate bets with, say, Germany. Then, if Japan defaults on the money they owe LTCM, the German options they have secured will also dry up. The German institution with which LTCM was trading will then also be out of the money it expected to receive from LTCM. It is then clear that supply and demand for li …