Tuesday, August 30, 2005

Long Term Capital Management 6 comments



(P.S: Sorry for any disturbances the advertisements above may have caused you)
Nowadays when people talk about whether high IQ rocket scientist-type geeks can succeed in the financial markets, the story of Long Term Capital Management invariably comes up in the case against. The 1998 collapse of the multi-billion dollar hedge fund was memorable for the fact that it had Nobel Prize-winning economists and legendary traders among its staff, and it was a shock to many when the fund made huge losses. However, to dismiss LTCM and its managers as complete failures would not be fair to them; their basic fund management premise was acknowledged, even after the event, as technically sound but ultimately they paid the price for assuming too much risk.

The well-known characters in LTCM were John Meriwether and the Noble Prize-winning economists Myron Scholes and Richard Merton. John Meriwether had been a star trader at Salomon Brothers before he started LTCM, drafting in the abovementioned two economiists who later shared the Nobel Prize for their work in describing the pricing of options, which would later be known as the Black-Scholes options pricing model which is a standard menu item on most finance texts. Of course, there were other lesser-known but probably no less intelligent traders in the LTCM trading office, but the main drawing power was the reputations of LTCM's management, which attracted major banks and savvy Wall Street veterans to invest with LTCM.

Arbitrage was the main operating strategy of LTCM, and the usual trading instruments were derivatives. The prices of derivatives such as options would usually be linked to their parent security instrument (a stock, bond or currency) and other "sibling" derivatives (ie. same parent security) in such a way that buying the derivative and selling its parent security /sibling derivative would yield no net financial gain to the trader ie. there was no arbitrage spread. However, occasionally there was such an arbitrage spread, and that was where LTCM would come in and take advantage by buying the under-priced derivative while simultaneously selling the over-priced one. The basic academic premise (there had to be, with two Nobel Prize winners in their midst) was the Efficient Market theory; a rational market would always price financial instruments efficiently, and close the arbitrage gap. Such "convergence plays" were very successful in the early years; a dollar invested in 1994 was worth more than two dollars two years later.

This arbitraging strategy necessitated use of high leverage since the spreads were usually very small, which was why trading in derivatives was very convenient since derivatives by their nature allowed high amounts of leverage on the parent security. But basically, this also meant that a risk-free strategy was turned into a highly risky bet on the nature of the markets by serving as a giant magnifier. If spreads failed to converge, LTCM might have difficulty finding adequate additional collateral capital (anyone playing margin on stocks would know). The initial years of success had made the partners more adventurous, such that by 1997-98 they were apparently using a leverage ratio of 30 to 1 ie. $30 of borrowings (margin) for every $1 of equity.

In 1998 the Russian bond market collapsed due to the Russian government defaulting on payments on its bonds. Although the exposure of LTCM itself to Russian bonds was small, the Russian collapse triggered a massive flight to liquidity by global bond investors to the safety of US Treasuries, temporarily causing spreads to diverge instead of converging especially in the case of short-term vs long-term US Treasuries. The inter-linkages between LTCM's positions were complex, but basically they had not hedged for this flight to liquidity in their supposedly failproof strategy, an omission further magnified by their high leverage ratios. Hence during this crisis they faced a liquidity crunch and a compelling need to unwind some of their positions to redeem cash so that other positions could be shored up.

The problem was that LTCM had grown so big that as soon as other big market players heard of its problems, they stopped buying. Nobody knew how the forced liquidation of LTCM's portfolio would affect prices, so traders pulled back. Hence market panic, another key unknown normally unaccounted for in academics' "rational market", now came in to deal LTCM another blow. There was a buying vacuum which exacerbated LTCM's precarious position, and soon caused concern to the Federal Reserve who were afraid that LTCM's collapse would pull down Wall Street together with it in a potential systemic meltdown. A consortium of banks and investment houses were pulled together to provide LTCM the capital, in exchange for 90% of their equity, so that the fragile markets would not have to absorb a forced liquidation of LTCM's assets. And thus a complete collapse was averted.

But LTCM would never be the same again. There was little mention of the fund in news articles after the rescue effort and I myself find it strange that it seems to have faded into oblivion without as much as a mention. However, footnotes revealed that the banks that supplied the funds for the rescue, such as Merrill Lynch, Credit Suisse, UBS etc had to take huge writedowns on losses for the investments (in LTCM during the rescue effort) in the later part of 1998. This was in addition to their earlier investments in LTCM when it was riding high during the mid-1990s. A case of "when genius failed", according to Roger Loewenstein in his book of the same title.

References:
(1) The Mind of Wall Street (by Leon Levy)

 

 

6 Comments:

Blogger Free Traffic System said...

Hello,

I liked your blog. I found many interesting information here.
I also give free info about forex forex forex forex forextraderguide.info guide trader trading trading trading on my
href="http://www.WebTradingSystem.com">Forex Trading System
site.

If you have time please visit my web site to get some free forex forex forex forex forextraderguide.info guide trader trading trading trading
information.

Kind regards,
Nick

10/16/2005 4:50 PM  
Anonymous Anonymous said...

Hi DanielXX, I was searching online for some free forex trading ebooks related sites and a I came across your post. I normally don't take the time to look at blogs but today I made an exception. After searching for about an hour for free forex trading ebooks it is nice to find a post that is helpful. Thanks.

10/28/2005 9:16 PM  
Anonymous Anonymous said...

Hi DanielXX. So many sites I visited today, while looking for free forex ebooks pages to post to my blog, were full of garbage. It was nice to find something real at your site. Well, I better go look for some more free forex ebooks pages for my own readers. Thanks.

10/30/2005 8:37 PM  
Anonymous Anonymous said...

Hi DanielXX, Today I took some time to look for free forex ebooks related pages. I have a site related to free forex ebooks and I sometimes search in the blogs, looking for new article ideas. Today it was a joy to come across a real interesting post that you made. Thanks for keeping it real.

10/31/2005 9:03 PM  
Anonymous Anonymous said...

Hi DanielXX, Today I took some time to look for forex trading ebooks related pages. I have a site related to forex trading ebooks and I sometimes search in the blogs, looking for new article ideas. Today it was a joy to come across a real interesting post that you made. Thanks for keeping it real.

11/02/2005 3:24 PM  
Anonymous Anonymous said...

Hi DanielXX, I was searching online for some free forex strategies related sites and a I came across your post. I normally don't take the time to look at blogs but today I made an exception. After searching for about an hour for free forex strategies it is nice to find a post that is helpful. Thanks.

11/05/2005 11:23 PM  

Post a Comment

<< Home