Introduction

In the case of Long-term capital management, one can find the rise and fall of hedge
funds in the past two decades. It exhibited a vivid image of Wall Street where its fund managers
ambitiously leveraged their portfolios and provided extremely high returns and fell to lose
clients money all of sudden.

Background information

Hedge fund industry is a deregulated one comparing to mutual fund and other investment
firms. It had not been enforced by law to notify its clients with investment strategies or change of
portfolios while management fee was named by hedge funds. The nature of its secret of
investment strategy was no different than investing in mispricing financial products and earns
profit at the spread of borrowings and return of investment.
In early 1994, the former vice president of Salomon Brothers John Meriwether resigned
from his post because of failure of regulating his traders. He soon started Long-term capital
management (LTCM) that recruited several experienced elites partners including an Economic
Nobel Prize winner and former vice chairman of Federal Reserve. It expanded at super speed that
on its first day, LTCM raised capital of $1.3 billion from all over the globe including Bank of
Italy and other investment banks. Its founding partners also contributed $100 million. LTCM
required its clients to have a lock up period of three years with a minimum of $10 million and it
will charge 2% of the funding and keep 25% of the profit. Such tight restriction was not irritating
investors, by 1997, LTCM held a total funding of $7 billion in total. LTCM performed

outsmarted its competitors; it delivered $2.7 billion in total return to its clients.As its success
came along, LTCM was confident and searched for more return. Its leverage ratio had piled up to
30%. (See exhibit 1)

Analysis
LTCM was no different than other financial institutions, it aimed to find mispriced
financial products, invested them with proper hedges on the side. LTCM longed undervalued
assets and sold short similar assets that were slightly overvalued. It used pair trade accordingly. It
also provided more utility while thewaitofconvergenceorthespreadtogenerateprofitsandthis
arbitragetechniqueseemedtobefairlyvaluedatlowriskafterall.Threeessentialpillarswere
adoptedbyLTCM:LeverageenabledbyrepofinancingandcontrolledbyValueatRisk.
LTCMusedhighleverageratiotoenhanceitsperformances.Inthearticle,onecanfind
thatbyyearof1998,LTCMsleverageratiohadboostedto2500%.Atthattime,itsassetswere
$5billionanditsborrowedfundingworthabout$120billion.LTCMwouldmakeaprofitatthe
spreadatrateoffinancingandreturnofinvestment.(Exampleseeexhibit2)
Topileupitscapital,LTCMusedrepofinancingwhichmeanttorepurchaseagreement
betweentwopartiesovernight,andLTCMwouldrepurchasetheassetthenexttradingday.That
wouldallowLTCMpossessedmorecapitaltoinvestinhigheryieldassets.Rollingoverthis
process25timeswascommonforLTCM.OnethingwastorememberLTCMalwaystookthese
opportunitiestoinvestwherethereexistspreadsbetweenassets.
LTCMhadawellfunctionedriskdepartment.Itreportedtosuperioronadailybasisof
summaryonValueatrisk.Itprovidedtheworstscenariosthatthemaximumlossatparticular

investmentataparticularperiodoftimelineoverall.Themodelwasbuilttoavoidmajormarket
shockwhereBlackSwanscouldhappen.
TheproductthatLTCMconcentratedonwasfixedincomesecurities.Itsearchedfor
globalmispricingsecuritiesandmacroinvestmentopportunities.Indomestictrading,itfocused
onarbitragingUSGovernmentbonds.Itsmainstrategycalledontherunforofftherunin
longtermUStreasuries.LTCMfoundshorttermUSgovernmentbondmaturinginsixmonths
weregenerallyslightlyoverpricedwhichinvestorswouldpaypremiumofitspossession.Onthe
otherhand,LTCMfoundlongtermUSgovernmentbondmaturinginthirtyyearsweregenerally
slightlyundervalued.Thereexistedaspread.Becauseofdifferentyields,LTCMlongedcheaper
bondsyieldhigherandshortsoldmoreexpensivebondsyieldloweratonce.Thespreadcreated
spaceforarbitrageopportunities.
Thegeneralofarbitrageproceededinthefollowingorder:LTCMshortsold$1billion
worthofthirtyyeartreasurybillsatpriceof$998percontract,thisgaveLTCM$998million
cashifthehaircutwas1%andinterestratewas4%.ThenLTCMwouldclearitspositionby
repurchasingthembackatalowerprice.Thenitwouldlongthirtyyeartreasurybillswitharepo
agreementwithotherfinancialinstitutionsthathaircutandinterestwassettoreceivecash.Then
itwouldsellthem.
Anotherderivatewasswappingoninterestratespreads.Itwasdesignedtoprovide
convergencewithexposureoflowrisk.Itwasconcentratedtofindthespreadbetweenlong
positionsintreasurybillsbyfinancingwithafloatingrate.Twoscenarioswerepresented:

1)Lowswapspread:Thespreadbetweenfixedinterestratepaymentonswapandidenticalasset
wasloweraccordingtohistoricaldata,LTCMwouldrepurchasewithrepo,thecashflow
generatedwouldbe:
(Treasuriesyieldfixedswapinterestrate)+(LIBORreporate)
=swapspread+[LIBOR(LIBOR20basispoints)]
=20basispointsswapspread
2)Theoppositeoflowswapspreadwheretheswapspreadwashigheraccordingtohistorical
data,LTCMwouldfinancewithshorttermidenticalassetandenterrepoatLIBORrate.The
cashflowgeneratedwouldbe:
(Fixedswapinterestratetreasuryyield)+(ReversereporateLIBOR)
=Swapspread40basispoints.
LTCMalsotradedindicesoptions.Itbelievedcurrentmarketvolatilityexceeded
predictionaccordingtohistoricaldata.Itusedstraddlewhichreferredtolongthecallandput
optionofanassetatthesameexercisepriceandmaturity.(Exampleseeexhibit3)Writinga
stranglewasanotherderivatethatLTCMusedoften.Itreferredtospeculationswith
combinationsofwritingcallandputoptionsatonce.Itdifferedwithstraddlewithoutofthe
moneyputandcallwithdifferentexerciseprice.(Exampleseeexhibit4)
LTCMalsotradedpairstockswhichidenticalstockswereshortsoldandlongedatsame
timewithaimingconvergence.InthecaseoftradingShellstockandRoyalDutch,LTCMlosta
betof$286millioninparttrades.LTCMalsousedpairtradeinM&Aassets:Longtargetfirm
andshortacquiringfirm.ButLTCMlost$150milliononTellabsdealwhichdealwaswithdrew.

Thefallbeganwhichmacroconditionshitthemarket.FinancialcrisisofAsianmarket,
rubbledevaluation,shrinkingyieldspreadinbondetc.AllthesefactorshaddrivenLTCMinto
apositionthatitcannotdeliverhighreturnaspreviousyearsunderitsmechanismofinvestment.
(Detailsseeexhibit4)Asaresult,undertheaidofFederalReserve,LTCMwasbailedoutwith
$3.5billion.

Conclusion and Lessons

ThecaseofLTCM,investorsshouldrealizehighreturnswerenotstableandanyprecious
hedgestrategyreliesonhistoricaldatawasnotsteadyasrocks.Threemostwarninglessonsare:
1) Investorsshouldperformduediligencenomatterwhatinvestmentfirmhasbeen
outperformingthemarket,andinvestorsshouldbealwaysnotifiedwithcurrentrisk
positionthattheyaredirectlyandindirectlyinvolvedwith.
2) Deleveragerequirementfromregulations.Itnecessaryforregulatorstoinform
investmentfirmstohandinaspecificscheduleofdeleveragealsocopiedtoclients.
3) Investmentfirmsshouldnotalwaysrelyhedgingstrategyonspreadofpairtradeorcall
andputoptions.Therearemacroeconomicfactorsandotherunseenindustrialriskthat
couldnotbehedgethiswayinanyfinancialproduct.

Exhibit1

Exhibit2

Exhibit3

Exhibit4

Exhibit 4