Long Term Capital Management
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 occurrence of those big losses was largely associated with the young professors who had had being masters of it for several years.
Those 3 billion and 4.4 billion dollars killer blows were as a result of Meriwether and his team bets which they had being making for almost a decade. Long-term options and interest-rate swaps were those bets which were the other behaviors exhibited by the market participants. LCTM maintained Swill-like neutrality since these two bets requirement was that you should buy one security and sell short the other according to strategists. The thing had similarity with what they sold. Most models who had predictions on the position of things in future like in five years never knew what might happen within this period before those five years come to an end. This brought 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 this led to unwound of trades by the big financial firms which were just like the Long Term Capital trades. These led to a loss of 550 million dollars in the Long Term Capital.
Asian crisis is another factor that led Long Term Capital Management to collapse. Whereby international investors has reluctance in lending funds to developing countries which resulted to slowdowns in developing countries. Therefore this negative shock caused a decrease in oil’s price causing financial pinch on oil exporters. Oil revenue reduction resulted to 1998 Russian financial crisis which contributed to collapsing of Long Term Capital Management in United States. After going through most of the analysis of LTCM case, the main factor that led to LTCM collapse was LTCM excessive leverage which was through its balance sheet and the off-balance-sheet exposures. During Russian crisis there was increase in price of the most liquid securities that LTCM was short of and reduction in price of the less liquid securities that LTCM mostly owned. This phenomenon occurred across all financial assets and US Treasury market therefore led to a very big loss to LTCM of about 1.85 billion dollars.
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.