LTCM Final Presentation | Long Term Capital Management | Arbitrage

FUTURE, OPTION & OTHER DERVIVATIVES

TOPIC NUMEBR .2. LONG TERM CAPITAL MANAGEMENT

Presented To: Mr. Pushkal Pandey

Presented By: Avijeet Kumar Atul Jain

INTRODUCTION
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LTCM was founded in 1994 by John Meriwether, the former vicechairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences. Initially enormously successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis and became a prominent example of the risk potential in the hedge fund industry. The fund folded in early2000.

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FOUNDING
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In 1993 he announced that he would launch a hedge fund called Long-Term Capital. Meriwether used his well-established reputation to recruit several Salomon bond traders and some brilliant mathematicians. He also recruited two future Nobel Prize winners, Myron Scholes and Robert C. Merton. In late 1993, Meriwether approached several "high net-worth individuals" in an effort to secure start-up capital for Long Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments. The bulk of the money, however, came from companies and individuals connected to the financial industry. By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.

• Pairs trading is a strategy that uses two highly correlated financial instruments (eg CocaCola and Pepsi) whose price relationship has divergerged outside of the historical range. In buying one and selling the other, the strategy aims to profit from the price reverting back to as the mean trend as the spread between the two converges. • Fixed-income arbitrage is primarily used by hedge funds and leading investment banks. The most common fixed-income arbitrage strategy is swap-spread arbitrage. This consists of taking opposing long and short positions in a swap and a Treasury bond. Such strategies provide relatively small returns and, in some cases, huge losses.

TRADING STRATEGY
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The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. Government bonds are a "fixed-term debt obligation", meaning that they will pay a fixed amount at a specified time in the future. CONVERGENCE MEANS Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high,

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LTCM DOWNTURN FACTORS

IMPACT ON LTCM
• EAST ASIAN FINANCIAL CRISIS  Because of the1997 East Asian financial crisis. In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $461 million.

• RUSSIAN FINANCIAL CRISIS  The Russian financial crises in August and September 1998, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August, the fund had lost $1.85 billion in capital. •

EAST ASIAN FINANCIAL CRISIS
• • Asia attracted almost half of the total capital inflow to developing countries. The economies of Southeast Asia in particular maintained high interest rates attractive to foreign investors looking for a high rate of return. • As a result the region's economies received a large inflow of money and experienced a dramatic run-up in asset prices. At the same time, the regional economies of Thailand, Malaysia, Indonesia, Singapore, and South Korea experienced high growth rates, 8–12% GDP, in the late 1980s and early 1990s. • This achievement was widely acclaimed by financial institutions including the IMF and World Bank, and was known as part of the "Asian economic miracle".

CAUSES OF EAST ASIAN CRISIS
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In the mid-1990s, Two factors began to change their economic environment. 1. The U.S. economy recovered from a recession in the early 1990s, the U.S. Federal Reserve Bank under Alan Greenspan began to raise U.S. interest rates to head off inflation. 2. For the Southeast Asian nations which had currencies pegged to the U.S. dollar, the higher U.S. dollar caused their own exports to become more expensive and less competitive in the global markets.
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And because of this Southeast Asia's export growth slowed dramatically in the spring of 1996, deteriorating their current account position.

RUSSIAN

RUSSIAN INCOME

• • Petroleum, natural gas, metals, and timber accounted for more than 80% of Russian exports, leaving the country vulnerable to swings in world prices. Oil was also a major source of government tax revenue. •  FACTOR FOR RUSSIAN FINANCIAL CRISIS

• The Asian financial crisis that had begun in 1997 and this crisis declines in demand and price for (and thus price of) crude oil and nonferrous metals, impacted Russian foreign exchange reserves.

OIL PRICES

Almost 10 USD /barrel

RUSSIAN FINANCIAL CRISIS
• • Two external shocks, the Asian financial crisis that had begun in 1997 and the following declines in demand for (and thus price of) crude oil and nonferrous metals, impacted Russian foreign exchange reserves. • A political crisis came to a head in March when Russian president Boris Yeltsin suddenly dismissed Prime Minister Viktor Chernomyrdin and his entire cabinet on March 23. • In June Kiriyenko hiked GKO interest rates to 150%. • On August 13, 1998, the Russian stock, bond, and currency markets collapsed as a result of investor fears that the government would devalue the ruble, default on domestic debt, or both. Annual yields on ruble denominated bonds were more than 200 percent.

CRISIS

LTCM CRISIS

ILLUSTRATION
• • Lowenstein reports that LTCM established an arbitrage position in the dual-listed company (or "DLC") Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8-10% premium relative to Shell. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch. LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge. This may have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22%, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.

BAILOUT PACKAGE
• • • • • On September 23,Goldman Sachs, AIG, and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Buffett gave Meriwether less than one hour to accept the deal; the time period lapsed before a deal could be worked out

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