Lessons From the management of long-term capital
Background
Long Term Capital Management (LTCM) hedge funds Brothers was founded in 1994 by John Meriwether, a very successful bond trader at Salomon. At Salomon, Meriwether one of the first Wall Street to top researchers and professors had to rent. Meriwether was a team of scientists, the models in the theories to trading based application. Meriwether at Salomon group of geniuses generated amazing returns and demonstrated an unprecedented abilityprecisely calculate risk and market factors.
Founded in 1994, Meriwether and LTCM Salomon left. The partners included two Nobel Prize economist, former Vice Chairman of the Board of Governors of the Federal Reserve, a professor at Harvard University and other successful bond trader. This elite group of merchants and scientists attracted initial investment of approximately $ 1300000000 by many large institutional clients.
Strategy
TheStrategy of LTCM was to be implemented on a simple concept, but difficult. LTCM used computer models to find arbitrage opportunities between markets. LTCM, the central strategy of convergence trades was when the securities were priced incorrectly relative to each other. LTCM long positions would be made under favorable safety and short positions in security are too expensive.
LTCM engaged in this strategy in international bond markets, emerging markets, U.S. Treasury bonds and other markets. LTCMThe money would be returned if it spreads and reduced the fair value of do. Later, when the capital base of LTCM Fund engaged in strategies outside their expertise, such as merger arbitrage and S & P 500 increased volatility.
These strategies, however, focused on small price differences. Myron Scholes, a partner, said, "Nickels LTCM as a giant vacuum cleaner that absorb all had overlooked another function." In a significant profit on small differencesValue of the positions of highly leveraged hedge funds. In early 1998, fund assets of approximately $ 5,000,000,000, and had borrowed over 125 billion dollars.
Results
LTCM achieved excellent performance at first. Before charges, the fund gained 28% in 1994, 59% in 1995, 57% in 1996 and 27% in 1997. LTCM earned those returns with volatility downward surprisingly little. In April 1998, the value of a dollar invested has risen to $ 4.11.
But halfIn 1998, the Fund began to suffer losses. These losses were further compounded when Salomon Brothers left the field referee. Later in the year to preserve Russia defaulted on government bonds, an LTCM. Investors panicked and sold Japanese and European bonds and bought bonds of the United States. Sun spreads between increased Holding LTCM, losing huge amounts of traffic arbitrage. LTCM lost $ 1850000000 capital by the end of August 1998.
Spread between LTCMArbitrage trades and further expand the fund is experiencing a flight to liquidity, assets created in the first three weeks of September from 2.3 billion dollars shrink to 600 million dollars. Although returns on assets due to shrinking use of leverage, the value of the portfolio has not. However, the increased acceptance of the assets of the Fund's leverage. catalyzes Ultimately, the Federal Reserve Bank of New York at $ 3625000000 bail-out by large institutional creditors to avoid a wider collapsefinancial markets caused LTCM leverage dramatic and large derivatives positions. At the end of September 1998, has invested the value of a dollar fell to $ 0.33 before charges.
Lessons from LTCM's Failure
excessive consumption of influence 1.Limitation
When engaging in investment strategies based on market prices of securities from converging to an estimated fair price, managers must be able to have a time long-term standunfavorable price changes. The dramatic use of leverage, the ability of capital invested in long-term adverse changes in prices is limited by the patience of creditors. Normally, lenders lose patience, as market crisis if borrowers need of capital. If the securities while an illiquid market crisis forced the fund will not.
LTCM, the use of leverage has also highlighted the lack of regulation in over-the-counter (OTC) derivatives market. Many of the loans andReporting requirements established in other markets such as futures, were not on OTC derivatives. This lack of transparency means that the risk of leverage dramatic LTCM are not fully recognized.
The failure of LTCM not mean that any use of leverage is bad, but highlights the potential negative consequences of excessive borrowing.
2.Importance Risk Management
LTCM not different aspects of risk management internally.Agencies primarily on theoretical models and not enough on liquidity risk, risk, vulnerability, and stress tests concentrated.
With such large positions LTCM should have focused more on the liquidity risk. LTCM model is the probability of a crisis and the possibility of a flight to liquidity underestimated.
LTCM models also assumed that both long and short positions are highly correlated. This hypothesis was justified historically. Wins list does not guarantee future results. Stress test for modelreduction potential of correlations could have managed risk better.
In addition to LTCM, the hedge funds, large institutional creditors have the right to risk management. Impressed by the concessionaire All-Star Fund and large quantities of goods, if the credit terms very generous to many believers to exercise even if the creditors in considerable danger. Not many creditors to understand its total exposure to certain markets. During a crisis, the exposure in different areas of a companyspecific risks could cause dramatic damage.
3.Supervision
LTCM would not have a truly independent monitoring of the operators. Without this control, the operators were able to create positions that were too risky.
LTCM an interesting case that shows the limits of the predictions based on historical data, and the importance of recognizing the potential failure of models. It also shows the story of LTCM, the risk of limited transparency in OTC derivativesMarket.
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