Long term capital management
This presentation is the property of its rightful owner.
Sponsored Links
1 / 51

Long Term Capital Management PowerPoint PPT Presentation


  • 128 Views
  • Uploaded on
  • Presentation posted in: General

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

Download Presentation

Long Term Capital Management

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


Long term capital management

Long Term Capital Management

Finance 4820


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


Leverage risk more than lt return vol

Leverage Risk - More Than LT Return Vol


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


    Fnma mbs oasl 1995 2007

    FNMA MBS OASL 1995-2007


    Long term capital management

    LTCM

    • Founded February, 1994

      - Capital $1 Billion

      - Principal’s Share $146 MM


    Salomon bros pretax income

    Salomon Bros. Pretax Income


    Ltcm results

    LTCM Results


    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


    Leveraged returns before after 1998

    Leveraged Returns Before/After 1998


    Leveraged returns during 1998

    Leveraged Returns During 1998


  • Login