What behaviors were being exhibited by market participants other than LTCM, and how did they contribute to the company’s downfall?
Long Term Capital Management’s main strategy to trade funds was making convergence trades. Convergence trades involved finding mispriced securities relative to one another. LCTM underwent very big losses that destroyed it and those big losses mostly occurred in the areas of the young professors who for several years had been masters of.
The 3 billion and 4.4 billion dollars killer blows came from certain bets that Meriwether and his team were making for at least a decade. These bets were interest-rate swaps and long-term options in the stock market which were the other behaviors exhibited by the market participants. LCTM maintained Swill-like neutrality since these two bets required that strategists were to buy one thing and sell short another. The thing they bought was similar to the one they sold. Most models can predict where things will be in the coming five years but can’t predict what will happen before you get to that moment of certainty. This brings us to what caused LCTM to collapse which was first due to red and blue dollars. Whereby Salomon Brothers liquidated all of their red-blue dollar trades which led to a 10% drop in LTCM funds.
On Aug. 17, big financial firms had a recant on their beliefs on red and blue dollars due to Russia default on paying their debt. Therefore the other big financial firms unwound their trades which were identical to the trades of Long Term Capital. These led to a loss of 550 million dollars in the Long Term Capital. In conclusion, to avoid a future collapse of hedge funds, finance firms should consider liquidity risk as a factor. We should classify securities as liquid and illiquid whereby liquid securities have positive exposure to liquidity factor and illiquid have negative exposure. If LCTM used this approach would have avoided the crisis. Still, we should ensure that models are stress-tested and still combined with judgment.