1 / 49

Long Term Capital Management

This text explores the conflicting objectives between investment managers and investors, detailing the pursuit of large, consistent risk-adjusted returns versus the asset-gathering goals of investment managers. It delves into various concepts such as risk premiums, the allure of alpha, and the intricacies of hedge fund operations. Key challenges include transparency, high fees, and the dangers of excessive leverage. The piece also highlights historical insights from LTCM and emphasizes the need for robust risk management strategies amidst market volatility.

zelda
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. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Long Term Capital Management Finance 4820

  2. Conflicting Goals • Goal of investment manager is to gather assets • Goal of investor is large, consistent risk-adjusted returns

  3. 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

  4. Alpha is King • Investors want “repeatable” alpha • Like quality earnings • As a result, managers present process in terms of approaches investors see as “repeatable”

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. Leverage Risk - More Than LT Return Vol

  12. 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

  13. Archipelago Limit Order Book Apparent bid/ask Of 10 cents

  14. 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

  15. Practical Problems With Var • Conditions are not stationary • Including correlations • Limited data • Liquidity crises • Fat tails in financial markets

  16. Sample Strategies • Government Bond Spreads • Swap Spreads • Yield Curve Spreads • Mortgage Spreads • Volatility Spreads • Risk Arbitrage • Equity Relative Value

  17. 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

  18. 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

  19. FNMA MBS OASL 1995-2007

  20. LTCM • Founded February, 1994 - Capital $1 Billion - Principal’s Share $146 MM

  21. Salomon Bros. Pretax Income

  22. LTCM Results

  23. LTCM 12/97 • Capital $7.5 Billion • Principal’s Capital $1.9 Billion • Assets $129 Billion • Off Balance Sheet > $1 Trillion

  24. $ Billions Net Income $1.0 Assets $129.4 Equity $7.4 Contractuals $1,317 Morgan Stanley 1996

  25. 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)

  26. Back Office Complexity • 7,600 Positions • 6,700 Contracts • 55 Counterparties • Inability to Net Across Legally-Distinct Entities within Large Firms

  27. 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

  28. Risk Management • Downside Risk Diminishes as Value Discrepancies Become Extreme • Leveraged Investors Commit First, Followed by Unlevered Investors • Stress Testing • Diversification

  29. Correlations • Long-Horizon Correlations Driven by Fundamental Risks • Short- Horizon Correlations Driven by Fundamental Risks and Liquidity Effects

  30. 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.

  31. Fund Size • LTCM excess capital estimates of $2bn • Marginal Capital Earns Libor before Fees and Libor minus 2% after Fees • Return it! • Alternative Strategies?

  32. OOOPS……the Decision • Distribute $2.7bn on 12/31/97 • “Favor” Strategic and Early Investors • Management Exempt • Investors are MAD!!!

  33. 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

  34. 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

  35. 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

  36. Working Capital • Sources: Equity $2.95 Term Debt 0.23 Credit Facility 0.90 Total 4.08 • Uses of Working Capital: $2.10

  37. Lender Covenants • Credit Facility Terminates if YTD Loss is Greater than 50% • Contractual Agreements terminate if Fund Capital Falls Below $500MM

  38. Choices? • Liquidate? • Raise Capital? • Buy…gulp…More?

  39. 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?

  40. 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

  41. 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

  42. 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

  43. Issues Determining Staying Power • Who else Employs Similar Strategies? • Liquidity Shocks • Time Varying Risk and Return • Diversification • Funding Sources • Franchise Value

  44. 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

More Related