Group 5

The
Team

er
Schole Meriweth
s
Mullin
s Merton
“ Wise trader with better at
choosing and managing
talented people”
THE
ECONOMISTS
The Idea

Create a hedge
portfolio to reduce
risk
(Merton even
proposed that risk
When markets deviate from normal
could bepatterns
reduced and
to the
zero)
Historical Correlation

 Banking on market regularities such as the

differences between interest rates.
 It is generally assumed that the markets establish
some sort of equilibrium between rates. If
differentials deviate from their past values there is
the presumption that with time markets will re-
establish those equilibrium differences. Sometimes
the equilibrium difference between two rates is
zero and then one speaks of the convergence of
those rates
Strategic Investors

 Min Investment Of $100 mn

 Top financial organizations
 Fee charged at exceptionally high
rates
 25% of profit + 2% of assets + commit
funds for atleast 3 years
 Against 20% of profit + 1% of assets by
others
Raised $1.25 bn – largest funding
raised
Power Of Leverage

requity = rassets + L(rassets - rdebt)

 Return on equity capital = Return on overall

capital + Leverage ratio (r assets –
Intt. Rate on debt)

 If L is high – and capital earns a rate of

return greater than r debt -- All turns out to be
well
Lack Of Regulations
LTCM – The story said by charts
 What LTCM overlooked?
Power of leverage is a “two edged” sword
 If L is high and Rassets < Rdebts, can turn mildly
bad year into a catastrophe

 Risk

riskequity = (L+1)riskassets

 Equity risk of a leveraged firm is the risk of the

unleverage firm multiplied by a factor of (L+1)
Over-confidence

 The traders took a large number of

separate positions there was
effectively no benefits for risk-
reduction through diversification in a
financial crisis because, in effect,
most of the separate transactions
were the same bet on the
stabilization of the markets and a
return to equilibrium.
Investing too little in
Game Theory
 In oligopolistic market payoffs depend on
choices made by each participant and
participant’s rival.
 But LTCM got too big it became the
market;
 They returned $2.7 billion to investors to reduce
their size by giving money back to their
investors
 Rouble crisis
 Convergence turned into dramatic
divergence.
 Salomon’s exit
Model risk
In the graph, S represents the
current price of the stock. For a
current stock price S a hedge
ratio is determined which makes
the curve flat at S so any very
small change in the price of the
stock will leave the value of of
the portfolio unaffected
The losses from a significant
decline in the price of the stock
are limited to the value of the
stocks in the portfolio, but there
is no such limit to the losses on
written calls when the price of
the stock increases significantly
Unexpected correlation
 Crisis period caused exception( It Back fired)

When markets went into turmoil in 1998 is

investors panicked about risk. They wanted
certainty in that uncertain period. Investors fled the
unpredictable markets for quality securities, ones
with a high degree of certainty.
Thus higher differentials for the riskier securities
did not stop the flight to quality securities.
For LTCM which bet on the re-enstatement of
equilibrium conditions it was a disasterous time.
The firm began to lose hundreds of millions of
dollars each day
Stress Testing

 According to LTCM managers their stress

tests had involved looking at the 12
biggest deals with each of their top 20
counterparties. That produced a worst-
case loss of around $3 billion. But on that
Sunday evening it seemed the mark-to-
market loss, just on those 240-or-so
deals, might reach $5 billion. And that
was ignoring all the other trades, some of
them in highly speculative and illiquid
instruments
SCAPEGOATS HUNT

 Meriwether and his crew of market professors.

 The banks which conspired to give LTCM far
more credit, in aggregate, than they'd give a
medium-size developing country. Particularly
distasteful was the combination of credit
exposure by the institutions themselves, and
personal investment exposure by the
individuals who ran them.
• Merrill Lynch protested that a $22 million investment
on behalf of its employees was not sinister. LTCM was
one of four investment vehicles which employees
could opt to have their deferred payments invested
in. Nevertheless, that rather cosy relationship may
have made it more difficult for credit officers to ask
tough questions of LTCM. There were accusations of
"croney capitalism" as Wall Street firms undertook to
bail out, with shareholders' money, a firm in which
their officers had invested, or were thought to have
invested, part of their personal wealth.
 US Federal Reserve system.
 Although no public money was spent -
apart from hosting the odd breakfast -
there was the implication that the Fed was
standing behind the banks, ready to
provide liquidity until the markets became
less jittery and more rational. Wouldn't this
simply encourage other hedge funds and
lenders to hedge funds to be as reckless in
future?
 Poor information.
 Scant disclosure of its activities and
exposures, by LTCM, as with many
hedge funds, was a major factor in
allowing it to put on such leverage.
There was also no mechanism whereby
counterparties could learn how far LTCM
was exposed to other counterparties.
 Sloppy market practice,
 such as allowing a non-bank
counterparty to write swaps and
pledge collateral for no initial margin
as if it were part of a peer-group top-
tier banks
Offers to save LTCM

 Warren Buffet
 The Federal Reserve
 ?? Failure could have led to financial
crisis and the creditor banks were
entered into extending credit to LTCM as
their financial losses in general financial
crisis would be more than that what
they stood to lose if LTCM defaulted on
its loan. ??
Corrective Response

Increase Market Discipline

 Financial Institutions should increase

their own credit standards

 Increase Regulatory Oversight for the

Institutions that lend to Hedge Funds

Investment banks and
securities firms must use
following when assessing the
 Include due diligence assessments of the financial
risk of and
soundness a managerial
hedge ability
fund:of the counterparty,
including its risk profile.
 Require ongoing disclosure of financial reports,
supplemented by information on the prospective
volatility of the counterparty’s positions, as well as
qualitative reports.
 Impose collateral requirements to cover potential credit
exposures when insufficient information is available on
a counterparty’s creditworthiness.
 Should have its own credit limits on counterparty
exposures.
 Should have ongoing monitoring of a counterparty’s
financial position
 Thank
you!!