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    Case Study - Financial Markets

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    Razel Tercino
    Long-Term Capital Management (LTCM) was a hedge fund established in 1994 by notable figures from Salomon Brothers. Using complex models and high leverage, LTCM took large positions in fixed income arbitrage. By 1998, LTCM had $4.72 billion in equity but over $124.5 billion in debt, resulting in extreme leverage of over 25 to 1. The Russian financial crisis in 1998 caused LTCM to suffer major losses as their positions declined rapidly. By September 1998, LTCM's equity fell to just $400 million while liabilities remained over $100 billion, resulting in leverage over 250 to 1. Fearing the collapse could spread, Wall Street firms organized a $3.65 billion bailout to inject

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    Case Study - Financial Markets

    Uploaded by

    Razel Tercino
    36 views3 pages
    Long-Term Capital Management (LTCM) was a hedge fund established in 1994 by notable figures from Salomon Brothers. Using complex models and high leverage, LTCM took large positions in fixed income arbitrage. By 1998, LTCM had $4.72 billion in equity but over $124.5 billion in debt, resulting in extreme leverage of over 25 to 1. The Russian financial crisis in 1998 caused LTCM to suffer major losses as their positions declined rapidly. By September 1998, LTCM's equity fell to just $400 million while liabilities remained over $100 billion, resulting in leverage over 250 to 1. Fearing the collapse could spread, Wall Street firms organized a $3.65 billion bailout to inject

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    Long-Term Capital Management (LTCM) was a hedge fund established in 1994 by notable figures from Salomon Brothers. Using complex models and high leverage, LTCM took large positions in fixed income arbitrage. By 1998, LTCM had $4.72 billion in equity but over $124.5 billion in debt, resulting in extreme leverage of over 25 to 1. The Russian financial crisis in 1998 caused LTCM to suffer major losses as their positions declined rapidly. By September 1998, LTCM's equity fell to just $400 million while liabilities remained over $100 billion, resulting in leverage over 250 to 1. Fearing the collapse could spread, Wall Street firms organized a $3.65 billion bailout to inject

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    36 views3 pages

    Case Study - Financial Markets

    Uploaded by

    Razel Tercino
    Long-Term Capital Management (LTCM) was a hedge fund established in 1994 by notable figures from Salomon Brothers. Using complex models and high leverage, LTCM took large positions in fixed income arbitrage. By 1998, LTCM had $4.72 billion in equity but over $124.5 billion in debt, resulting in extreme leverage of over 25 to 1. The Russian financial crisis in 1998 caused LTCM to suffer major losses as their positions declined rapidly. By September 1998, LTCM's equity fell to just $400 million while liabilities remained over $100 billion, resulting in leverage over 250 to 1. Fearing the collapse could spread, Wall Street firms organized a $3.65 billion bailout to inject

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    © All Rights Reserved
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    Case Study: Collapse of Long-Term Capital

    Management
    CASE STUDIES, PRM EXAM IV, RISK MANAGEMENT

    Background of LTCM

    This article explains the causes of collapse of a major speculative Hedge Fund (Long Term
    Capital Management) way back in 1998. This fund was set-up by some very famous people,
    namely, John Meriwether from Salomon Brothers, Myron Scholes and Robert C Merton among
    other important names.

    The fund was setup as a fixed-income arbitrage, statistical arbitrage and Pairs Trading fund
    combined with some high leverage and because the master hedge fund Long Term Capital
    Portfolio L.P. failed in the late 1990s. Salomon Brothers were already an expert in this area.

    The company used complex mathematical models to take advantage of fixed income arbitrage
    deals usually with US, Japanese and European government bonds. The capital base grew due
    above average returns initially and the company decided to invest the capital and had run out of
    good bond-arbitrage bets. These trading strategies were non-market directional and were not
    convergence trades. By 1998 the firm had extremely large positions in merger arbitrage, S&P
    500 volatility options and became a big supplier of S&P 500 Vega. Because these differences in
    value were minute the firm decided to take highly leveraged positions to make a significant
    profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over
    $124.5 billion with assets of around $129 billion, for a debit to equity ratio of over 25 to 1.

    Causes of Collapse

    The causes of the LTCM collapse were is no way linked to the East-Asian financial crises of
    1998.
    There were some events in 1997 that led to this happening. On Monday, October 27, the DOW
    dropped 554 points. This 7% market share loss was termed as black Monday and the New York
    Stock Exchange shut down twice in an attempt to calm the market. Salomon Brothers’ exit from
    the arbitrage business in July 1998 further aggravated the situation.

    The Russian Financial Crisis of August and September 1998 which was caused due to the default
    of the Russian Government bonds further contributed to these losses. This was called the
    “Ruble” crisis and it resulted in the Russian Government devaluing the ruble and defaulting on
    its debt. Declining productivity and an artificially high fixed exchange rate between the ruble and
    foreign currencies to avoid public turmoil and a chronic fiscal-deficit were events that led to the
    crisis. The economic cost of the war in Chechnya (estimated at $5.5 billion) also caused this. The
    firm had investments in Japanese and European bonds and knowing that the Russian Crisis
    would affect the value of these bonds, the panicked investors sold their holdings and purchased
    US Government Bonds.

    LTCM had to liquidate a number of positions at a highly unfavourable moment and suffer further
    losses. The company which was proving almost 40 percent returns up to this point experienced a
    flight to liquidity. The equity value of the firm tumbled from $2.3 billion at the start of the month
    to just $400 million by September 25, 1998. With liabilities still over $100 billion this translated
    to a leverage ratio of more than 250 to 1.

    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 equity 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
    The Subsequent Bailout

    Wall Street feared that the downfall of LTCM could have spiralling effects in the global financial
    markets causing catastrophic losses throughout the financial system. Goldman Sachs, AIG and
    Berkshire Hathaway on September 23, 1998 offered to buy out the funds partners for $250
    million and decided to inject $3.75 billion and to operate LTCM within Goldman’s own trading
    division. The final bailout was $3.65 billion.

    LTCM continued normal operations after that.

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