HBS Case: Long-Term Capital Management, L.P.


1) Are the incentives of the Principals and employees of LTCM aligned with investors? The incentives for the principals and employees of Long Term Capital Management (³LTCM´) are aligned with investors. Principals and employees structured Long-Term Capital Portfolio, L.P. (the ³fund´) using three main tools to align interests: (i) a high employee ownership in the fund; (ii) a fee structure heavily weighted towards an incentive or performance fee; and, (iii) the matching of the fund¶s liquidity with the long-term investment horizon of most of the underlying trade. The first component is the single most important factor in evaluating employee incentives. By having LTCM employees¶ invest their capital alongside investors it automatically aligns interests. LTCM employees¶ capital accounted for almost twenty-five percent of the fund¶s total capital. Most of the employees of LTCM elected to contribute to the fund¶s deferred-compensation plan, which was also linked to the underlying performance of the fund. Additionally, principals reinvested almost all of the company earnings back into the fund. This creates large incentives for the employees of the fund to run the fund in a prudent manner and earn the best risk adjusted return for themselves as well as their Limited Partners. The second critical area of keeping incentives aligned is LTCM¶s fee structure. The fund charges a two percent management fee on assets under management and a twenty-five percent performance fee on all returns over the high-water mark of the fund. The management fee of two percent is at a competitive rate, is the standard management fee charged across the hedge fund universe and is meant to cover the operations of the management company. The twentyfive percent performance fee is a bit on the high side, but the fund has a high-water mark in place and the historical returns the fund has achieved provide support for higher performance fee. LTCM can only charge the performance fee above the funds high-water mark. Losses must be recouped prior to the fund charging the twenty-five percent incentive fee. The incentive fee keeps management focused and motivated to drive the performance of the fund and avoids having management just collect a management fee by sitting on underperforming assets. Thus, the fund¶s fee structure is setup in a way that LTCM must perform to earn large profits. The third component that helped align all investor interests is the liquidity terms of the fund. The fund¶s three-year lock fits the long-term investment horizon of the arbitrage strategies

If the position is held until maturity.e. (ii) when financing rates on bonds deteriorate relative to the London Interbank Offered Rate (³LIBOR´). Whether a swap-spread trade creates a loss or gain depends on whether one is purchasing the fixed or floating rate and the spread on the swap instrument. which would otherwise force the fund to sell positions at discounts and hurt all investors in the fund. In the first scenario. the repo rate increases relative to LIBOR) and thus the positive carry on the trade could evaporate. Investors can capitalize on this mispricing through arbitrage opportunities. In this case. 2) Describe the view that motivates the swap spread trade. Using the example on page 4 of the case. the narrowing of swap spreads does not in itself necessitate a loss.the fund is used. Thus. the fund can prevent massive runs on its equity base. How can this trade lose money? The view motivating the swap spread trade is that dislocations in the financial markets lead to a mispricing of various securities. LTCM borrowed funds at the repo rate and lent at a fixed rate. if the fund can hold the position to maturity it will make the positive carry of 3 basis points per year. . if the fund had liquidity problems and needed to unwind the position prior to maturity. The liquidity terms keep the interests of all investors in mind as the fund only allows for staggered maturities or redemptions. In the case of LTCM. the loss on the portfolio value (as a result of narrowing swap spreads) would be realized. and. A narrowing of the swap spread causes the value of a bond portfolio to go down because bonds mark-to-market every day. However. The second scenario involves periods where the financing rate on bonds deteriorates relative to LIBOR. the company was able to capitalize on arbitrage opportunities when the swap spread was sufficiently narrow or wide. A trade where one is paying fixed to receive floating can lose money in two scenarios: (i) when swap spreads narrow and the fund does not have sufficient liquidity. The profitability of the trade depends on the cost of financing the purchase of Treasury Bonds. it will be more expensive to borrow funds (i. The swap spread is the spread between the fixed rate on the swap and the yield on a treasury bond of comparable duration.. the bonds issued are repaid at par so any mark-to-market losses suffered during the time of the contract would be irrelevant.

the analysis of RMBS is more complicated than other fixed-income securities and sophisticated prepayment models are needed to properly value the securities as well as the underlying mortgage pools.5 basis points with 2% haircuts) and therefore could benefit from the positive carry it could create between the spread on the RMBS and the rate at which the securities could be financed. The fixed-rate mortgage trade could lose money in a numbers of ways: (i) prepayments on the underlying mortgages might be substantially larger than those predicted by LTCM¶s prepayment model causing the return on the RMBS to be less than expected. LTCM could finance RMBS at low rates (LIBOR minus 12. normally with interest rate swaps.3) Describe the fixed-rate mortgage trade. hedge out the interest-rate risk and benefit from the positive carry created on the trade. LTCM¶s view on swap spreads is reflected in their choice of hedge instrument because RMBS can be hedged with multiple instruments (Treasury Futures. At the same time the RMBS are collateralized by the borrowers¶ homes and presumed to be backed by the full faith and credit of the United States government (as they are financed by the quasi-government mortgage agencies. Thus. the trade might have to be unwound before the market value of the RMBS converges to the value calculated by the LTCM¶s prepayment model. Thus. but hold onto their mortgages when interest rates rise). when LTCM found a RMBS whose market value deviated materially from the fair value of the security calculated with the firm¶s prepayment model. making the instruments essentially default free. How can this trade lose money? Mortgages are typically hedged with either or a combination of Treasury Futures. As a result. Eurodollar Futures.S. government). swaps or a combination of all three securities). homeowners inconveniently tend to refinance or prepay their mortgage when interest rates fall. the company could buy the RMBS with 100% financing. RMBS trade at significant spreads to LIBOR (as high as 25 basis as indicated in the case). which have an implicit backing by the U. Eurodollar Futures or Swaps. (ii) due to liquidity issues. As a result of the embedded prepayment option within the underlying mortgages. Since RMBS have prepayment risk (that is. and. when swap spreads are extraordinarily wide (most . (iii) the financing for the trade may be more expensive than originally estimated causing the positive carry on the trade to disappear. How is LTCM¶s view on swap spreads reflected in their choice of hedge instrument? How would you hedge mortgages when swap spreads are extraordinarily wide? Or when swap spreads are at a normal/fairly priced level? The fixed-rate mortgage trade involves taking a long position in fixed-rate residential mortgage-backed securities (³RMBS´) and hedging out any interest-rate exposure.

On the other hand. which in turn had created a greater demand for downside protection. In the case of equities. Thus. LTCM priced the options based on historical volatility assumptions. LTCM believed that expected volatility. In addition. The buyers of these options would repackage the purchased options into structured products. In this case. 4) Describe how LTCM sells volatility in the fixed-income and equity option products. As interest rates go down. This is exemplified in page 8 of the case. LTCM felt that the price of current options was too low based on their prepayment models and . LTCM did lose money because volatility jumped well above the implied level of 20%. The forward price depended on a variety of factors including the expected volatility of the index.likely due to the credit risk element in LIBOR rates). as seen in near-term index option prices. LTCM would decide to hedge RMBS using Treasury Futures or Eurodollar Futures as the wider swap spreads would push up borrowing costs and cut into the positive carry of the fixed-rate residential mortgage trade. the strike price was equal to the forward price of the index. with interest-rate risk hedged through swaps. Selling a prepayment option is equivalent to selling volatility as discussed above. when swap spreads are at a normal or fairly priced level. A mortgage-backed security can be viewed as purchasing a non-callable bond and selling a prepayment option. The trade loses money if the actual volatility is higher than the implied volatility of the options. LTCM looked to capitalize on what they believed was a short-term mispricing in the options market. LTCM believed they could sell options with significantly higher implied volatilities than both the historical and implied volatilities on short-term options that were observed in the market. was higher than the actual volatility. some of the fund¶s mortgage trades involved a long position in interest only strips (³IO´). thus reducing the cost of the option. How can this trade lose money? How can the mortgage trade also be characterized as selling volatility? LTCM sells volatility by selling long-maturity put and call options on stock market indexes. They believed this was caused by investor nervousness due to struggles in the Asian economy. historical volatility was 10-13% but near-term options were pricing consistent with volatility of 20%. LTCM would use interest-rate swaps to hedge RMBS rather than Treasury Futures or Eurodollar Futures as the swaps are cheaper and easier to use as a hedging instrument. the risk of prepayment by the homeowner goes up causing the price of the IO position as well as the volatility of the prepayment option to go down.

thus had the ability to capitalize on arbitrage opportunities in the market by selling options. With stress tests. it is a probabilistic measure of loss potential to a specified level of statistical confidence. by performing stress tests on the portfolio. However. LTCM could assess the effects of changes in economic factors such as interest-rate movements. VaR can limit loss exposure. such as VaR and volatility predictions. 5) Discuss risk management at LTCM. Thus.e. with each position adding an incremental risk of 100%. Value at risk (³VaR´) is defined as the worst loss than can happen under normal market conditions over a specified horizon at a specified confidence level.. future movements in risk factors are similar to past movements) and are assumed to be normally distributed. whereas the portfolio risk for . on the economic profit and loss of the fund and use such information to determine the fund¶s need for capital to support its positions. However. a risk manager normally explores cases where they do not have enough data to estimate the risk accurately in the hope that by preparing for foreseeable events they can acquire the discipline to survive such events if they actually occur. especially during times of crisis when the correlations between most trades increase. yield-curve shifts or stock price movements. rather than stress testing for the underlying positions or managing the fund¶s liquidity risk. a 95% VaR indicates that there is a 5% chance that a loss greater than a certain value would be sustained in a certain time period. The effect of correlation among trades on portfolio risk is significant as demonstrated by Exhibit 3 of the case in which the portfolio risk for ten positions that are perfectly correlated is 1.000%. this approach to risk management assumes that the variances and correlations between positions do not change over time (i. because the fund can set risk limits for the maximum amount of risk it is willing to take over a certain time period and ensure it stays within these risk limits by measuring the portfolio¶s VaR. How does ³value at risk´ limit loss exposure? What information does ³stress testing´ provide? What is the effect of correlation among trades on portfolio risk? How can you test LTCM¶s correlation assumptions with the data in Exhibit 1? LTCM¶s risk management seemed to concentrate too much on theoretical market-risk models. Stress testing involves simulating significant past events and different future events on the trades within the fund to understand the underlying profit and loss from the portfolio over different time frames as well as the returns for the portfolio under various scenarios. Thus. the assumption for static risk factors does not always hold.

as the case indicates.7 billion in August of 1997. What course of action should they take? LTCM assets under management grew from $1. the Principals debated whether or not the Fund had excess capital. Furthermore. LTCM should use its core competencies and form a new fund focused on a slightly different strategy and market. with the tenth position adding only incremental risk of 16%. Diversification was no longer helpful in reducing the fund¶s risk as the value of nearly all the fund¶s positions (and all asset classes in general) was moving in lockstep. To restore scalability to the fund. Thus. LTCM should also return capital to investors by orderly unwinding positions and distributing 50% of all assets back to investors.ten positions that are perfectly uncorrelated is only 316%. This sent red flags to management that the fund had grown too large. while LTCM¶s portfolio generally benefitted from diversification. The new fund would have the opportunity to attract a large amount of seed capital from existing or new investors whose capital was turned away as a result of the fund¶s closure. Additionally. as the profits from the firm¶s diversified trading strategies were generally uncorrelated.1 billion in 1994 to $6. to be contributed to the fund. the funds size prevented LTCM from having the ability to be nimble and respond to changes in the market. the market remained irrational for a longer time-period than the fund could stay solvent. the fund began having difficulty sizing in and out of trades without moving prices. . which ultimately increased the correlation between the fund¶s positions. As a result. old or new. This general flight to liquidity led to a market-wide re-pricing of risk. The principals should not allow any additional capital. which left profits on the table and caused liquidity issues. As John Maynard Keynes is known to have said. the fund suffered large losses to its equity value as the correlation of the firm¶s positions increased. LTCM should have a hard close on the fund at yearend. Thus. the benefit vanished in August 2008 due to the general flight to liquidity in the capital markets. The enormous size of the fund began to impede LTCM¶s investment strategy. 6) In September of 1997. LTCM had become too large for the arbitrage markets that it operated in.