Essay about Long Term Capital Management

Submitted By cav360
Words: 2295
Pages: 10

Christopher Valdez
Fin 4385 – Derivatives
March 3, 2013

Long Term Capital Management Long Term Capital Management was a hedge fund management firm. They used absolute-return trading strategies to go along with high financial leverage. John Meriwether, who was once very successful with bond trading at Salomon Brothers, founded LTCM. He assembled an excellent team of traders and even brought some over from his previous company to begin this new company. Investors thought highly of this company right from the get go and invested $1.3 Billion at its inception in 1994. This new company seemed destined for success, especially after he recruited Robert Merton and Myron Scholes to his team. These were two of the most brilliant economic minds and were even awarded 1997 Nobel Memorial Prize in economic science. Just a quick glance at the members of the team and then you start to realize why investors were so quick to hop on board. As mentioned earlier, they were able to raise a substantial amount of capital since their inception. This should give you an idea of the market climate at the time. The 90’s were when the stock market was at a complete boom. The Tech bubble was huge during this time. Basically, if you couldn’t make money in the market, you were completely doing it wrong. LTCM’s strategy was mostly to take advantage of convergence trades. These trades work by buying one asset forward and selling a similar asset forward for a higher price in hopes that the prices will have become closer to equal. Your profits would then equal the amount of the convergence. This does not work all the time. Like with any other investments, there are risks. The main risk in this type of trade is that the expected convergence does not take place. The most dangerous thing that could happen is actually called divergence. This would basically mean that the prices would go in different directions instead of equaling out. Divergence leads to the trade temporarily losing money and the trader would be required to post margin, so they could end up facing bankruptcy. Divergence occurs more often during a financial crisis. It becomes increasingly difficult for investors with a good amount of leverage to raise capital. Now that you know a little bit of their strategy, let’s start to look at the LTCM strategy with their actual numbers. They used this convergence strategy and were able to make some returns, but they were not extremely outstanding returns. To make their returns seem more attractive, they decided to highly leveraged positions. In fact, they were taking so many highly leveraged positions that in 1998, they had a debt to equity ratio of about 25 to 1. They had equity of about $4.72 Billion and debt of about $124.5 Billion. Investors really did not know a lot about this because LTCM was so discreet in what they were doing. For a while, they had a right to be secretive because they were generating outstanding returns for a few years. They had returns of 43% in 1995, 41% in 1996, and 17% in 1997. LTCM’s capital grew from about $1 Billion to about $7 Billion in 1997. It was so profitable that they were able to charge almost whatever they wanted. Other hedge funds at the time were charging about a 1% fee on capital and roughly 20% of profits. LTCM, on the other hand, was charging a 2% fee on capital and approximately 25% of any profits. (Jorion) They were able to do all of this without even revealing their positions to the investors of the fund. They pretty much got away with murder. Another example that reveals how much they were able to get away with was a certain clause they had for their hedge fund. They required investors to keep the money they invested in the fund for at least three years. This was not common or typical. The strategy benefitted everyone for a while. Who could really argue with the type of returns they were generating, but in the long run, the strategy benefitted LTCM a lot more as only they knew what was truly going…