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Long Term Capital Management. Finance 4820. Conflicting Goals. Goal of investment manager is to gather assets Goal of investor is large, consistent risk-adjusted returns. Pay for What Performance?. Rf return - should be free Add market risk with risk premium - should be almost free

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conflicting goals
Conflicting Goals
  • Goal of investment manager is to gather assets
  • Goal of investor is large, consistent risk-adjusted returns
pay for what performance
Pay for What Performance?
  • Rf return - should be free
  • Add market risk with risk premium - should be almost free
  • Lever market risk and premium - should be almost free
  • Create alpha - costly
alpha is king
Alpha is King
  • Investors want “repeatable” alpha
    • Like quality earnings
  • As a result, managers present process in terms of approaches investors see as “repeatable”
hedge fund basics
Hedge Fund Basics
  • Lack of transparency
  • Fees, fees, fees 1% to 2% + 20% from zero!
  • Large returns needed for acceptable net
  • Typical promise:
    • Equity-like volatility
    • Equity-like returns
    • Uncorrelated with equities
  • “Guru” rather than establishment
  • Ability to cross markets
arbitrage
Arbitrage
  • Most over-used term in finance?
  • Arb = sure profit, zero investment, zero risk
  • LTCM able to pull off the “zero investment” part
  • LTCM positions were “not zero risk, sure profit”
    • Leverage becomes an issue
    • Correlation of positions becomes an issue
    • Maximum loss becomes an issue
      • Due to leverage, instantaneous maximum
trade types
Trade Types
  • Directional
    • Typical long or short (expected price movement)
    • Mkt timing Unlimited loss short, 100% long
  • Relative Value
    • Substitution or long/short
    • Expected price or risk premium changes
    • Potential loss more limited
  • Convergence
    • Like realtive value, but:
      • Always long’/short
      • End date/event that guarantees convergence

Less

Holding

Period

Risk

leverage
Leverage
  • Leverage + illiquid assets = bankruptcy
  • Traditional leverage
    • Borrow and purchase more assets
    • Increases portfolio assets and portfolio volatility or beta
  • Cashless leverage
    • Futures/options
    • OTC derivatives
    • Structured securities
      • These do not increase portfolio assets, but do increase portfolio volatility or beta
typical limits on leverage
Typical limits on Leverage
  • Investor policy statement
  • Internal reviews/controls
  • Over-collateralization (haircut)
    • Treasurys 2-3%
    • Agency MBS 4-5%
    • High-grade corporate 5-10%

Maximum leverage = 1 / haircut %

For MBS: 1/.05 = 20x

leveraging spread trades
Leveraging “spread” trades
  • Returns & especially spreads (risk premia) tend to mean revert
  • Extremely high or low risk premia tend to be temporary
  • Leverage makes the temporary permanent
market impact
Market Impact
  • Large trades can “move the market”
  • Bid/Ask on screen is not whole story
  • In addition to bid/ask, liquid market needs:
    • Low costs
    • Depth
archipelago limit order book
Archipelago Limit Order Book

Apparent bid/ask

Of 10 cents

quick review
Quick Review
  • Leverage Was Funded Primarily Through the Use of Swap and Repos
  • Little Capital Up Front, Cash Flows Reflected Margin and Mark to Market
  • ROA was Relatively Low/Huge Leverage

Magnified Returns

  • VAR and Stress Testing More Useful than Lvg. Ratios in Risk Management
practical problems with var
Practical Problems With Var
  • Conditions are not stationary
      • Including correlations
  • Limited data
  • Liquidity crises
  • Fat tails in financial markets
sample strategies
Sample Strategies
  • Government Bond Spreads
  • Swap Spreads
  • Yield Curve Spreads
  • Mortgage Spreads
  • Volatility Spreads
  • Risk Arbitrage
  • Equity Relative Value
trade preferences
Trade Preferences
  • Believed that Over Time Markets Tend Toward Efficiency
  • Limited Credit Risk in Outright Positions
  • Often Acted as a Source of Liquidity
  • Tried to Isolate the Desired Investment Risk and Hedge Away Other Risks
relative volatility of rates spreads 1990 2006
Relative Volatility of Rates/Spreads 1990-2006

Monthly SD

1.47%

.21%

7.0

1.33%

.23%

5.8

.11

Mean

5.48%

.49%

5.88%

.56%

.10%

5 Year CMT Rate

5 Year Swap Spread

Ratio Rate Vol/Spread Vol

10 Year CMT Rate

10 Year Swap Spread

Ratio Rate Vol/Spread Vol

FNMA MBS OASL

slide25
LTCM
  • Founded February, 1994

- Capital $1 Billion

- Principal’s Share $146 MM

ltcm 12 97
LTCM 12/97
  • Capital $7.5 Billion
  • Principal’s Capital $1.9 Billion
  • Assets $129 Billion
  • Off Balance Sheet > $1 Trillion
morgan stanley 1996
$ Billions

Net Income $1.0

Assets $129.4

Equity $7.4

Contractuals $1,317

Morgan Stanley 1996
long term financing
Long Term Financing
  • Equity Lock-Up (3year Staggered)
  • $230 Million Unsecured 3 year term Loans
  • $700 Million Unsecured Revolving Line of Credit, Annual Renewal
  • Term Repos (6-12 months)
back office complexity
Back Office Complexity
  • 7,600 Positions
  • 6,700 Contracts
  • 55 Counterparties
  • Inability to Net Across Legally-Distinct Entities within Large Firms
liquidity management
Liquidity Management
  • Capital Uses: Mark to Market Losses and Working Capital
  • Working Capital Uses: Financing Haircuts, Equity and Future Margin Requirements
  • Working Capital Sources:Equity Capital plus Term Debt plus Revolver
risk management
Risk Management
  • Downside Risk Diminishes as Value Discrepancies Become Extreme
  • Leveraged Investors Commit First, Followed by Unlevered Investors
  • Stress Testing
  • Diversification
correlations
Correlations
  • Long-Horizon Correlations Driven by Fundamental Risks
  • Short- Horizon Correlations Driven by Fundamental Risks and Liquidity Effects
fund size
Fund Size
  • Desired Volatility of 15-20%
  • Returns Uncorrelated with S&P 500
  • Expected Excess Return of $750MM
  • Daily P&L Sigma =$45MM

=$720mm p.a.

=10.7% of Capital

Models est. sigma=$60mm.$960 p.a.

fund size1
Fund Size
  • LTCM excess capital estimates of $2bn
  • Marginal Capital Earns Libor before Fees and Libor minus 2% after Fees
  • Return it!
  • Alternative Strategies?
ooops the decision
OOOPS……the Decision
  • Distribute $2.7bn on 12/31/97
  • “Favor” Strategic and Early Investors
  • Management Exempt
  • Investors are MAD!!!
1998 through june
1998 through June
  • January through April: Flat
  • May & June –16%, 4.1 Billion
  • Firm Cuts Daily Sigma by 10%
  • Liquidates Least Attractive (Most Liquid) Positions
july 1998
July 1998
  • Salomon Smith Barney Shuts Down US Fixed Income Arbitrage Group
  • LTCM Up 7% Through July
  • Then Pattern of Daily Losses Resumes Across Many Positions
  • Global Equity Markets Under Pressure
  • Globally Volatility Spikes
august 1998
August 1998
  • August 17: Russian Default, Flight to Quality
  • August 21: Fund Loses $550mm in (Risk Arb and Swap Spreads)
  • YTD down 40%, -$1.8BN, to $3bn
  • Leverage (Cash basis) Now 44x
working capital
Working Capital
  • Sources: Equity $2.95

Term Debt 0.23

Credit Facility 0.90

Total 4.08

  • Uses of Working Capital: $2.10
lender covenants
Lender Covenants
  • Credit Facility Terminates if YTD Loss is Greater than 50%
  • Contractual Agreements terminate if Fund Capital Falls Below $500MM
choices
Choices?
  • Liquidate?
  • Raise Capital?
  • Buy…gulp…More?
september investor letter
September Investor Letter
  • Losses of 52% YTD (to 2.3bn Capital)
  • YTD Losses of $2.5bn
  • 82% of Losses RV, 18% Directional
  • Positions Take Time to Efficiently Accumulate
  • Best Opportunities Ever Seen
  • Want to Come Out and Play?
september 1998
September 1998
  • Fund Raising Fails
  • Negative Rumors
  • Mkt Participants Bet Against LTCM
  • Liquidation of Similar Positions
  • Bear Stearns Demands More Collateral
  • Counterparties Mark to Worst
september 19981
September 1998
  • 9/21 One day Loss of $553 Million
  • Capital Below $1 Billion
  • 9/23 Consortium of Firms Put up $3.6bn for 90% ownership and Oversight
  • Not Capital Adequate Until February 99
ltcm losses 1 98 9 98
LTCM Losses 1/98-9/98
  • Fixed Income RV $1,628
  • Equity Volatility $1,314
  • Emerging Markets $430
  • Directional $371
  • Equity Pairs $306

Total $4,600

issues determining staying power
Issues Determining Staying Power
  • Who else Employs Similar Strategies?
  • Liquidity Shocks
  • Time Varying Risk and Return
  • Diversification
  • Funding Sources
  • Franchise Value
causes of ltcm failure
Causes of LTCM Failure
  • Arrogance - must be right
  • Lack of any controls
    • Internal
    • Investors
    • Lenders
    • Counterparties
  • Reliance on correlations
    • Not stationary
    • Market changes
    • Fat tails
  • Size of positions
    • Limited trading partners
    • They all know/watch each other
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