Ltcm Case Study

6.

  The major assets of LTCM were its financial portfolio, starting from primarily arbitraging the global bond markets, and the company diversified its portfolio as it grew. And the major source for LTCM to gaining its assets was leverage, and it continued to amplify the leverage as its portfolio getting diversified.

7.

  LTCM searched for numbers of low risk arbitrage deals, each deals had relatively small returns, but by using its billions of dollars of investment funds, LTCM was able to accumulate substantial earnings. Relatively few of LTCM’s trades were outright bets on the direction of individual assets’ price, but rather they were wagers on the spread between asset prices and the spread between yields.

Hence, LTCM needed abundant sources of credit and substantial market liquidity to reverse position quickly and at firm price, in order to execute this strategies and attain the desired risk-return goals.

So, LTCM needed to maintain a high credit rating to attract and keep its sources of finance and trade counterparties.

8.

  LTCM’s strategy was to use as little equity capital as possible, and equity was used to pay for necessities. In the absence of equity, LTCM financed most of its security purchases with reverse repos with 6-month to 12-month maturities. Under a reverse repo agreement, LTCM bought a bond, and then used it as collateral for a loan, the proceeds from which LTCM used to pay for a new bond.

LTCM minimized its use of equity by doing trade that mentioned above, and when LTCM’s interest costs were less than the return, the company can earn profits from the trade.

  LTCM also leveraged its positions by entering into over-the-counter total return swaps. In exchange for paying a fixed or floating rate of interest, these financial instruments gave LTCM the financial benefits of owning the underliers but spending only a little cost of equity expended.

9.

  There were two major endogenous factors that cause LTCM’s portfolio to lose the normal protections afforded by diversification.

  First, many other hedge fund tried to imitate LTCM’s successes in the past, the appearance of competitors weakened the advantage of LTCM, and the wider margins made those hedge funds hard to cover their losses. And investors tended to invest safer products, and hedge fund managers tried to reduce their exposures.

  Second, LTCM built what it thought was a portfolio of economically unrelated positions, but actually, many of those positions were somewhat correlated. And those unfounded correlations eliminated LTCM’s expectation for hedging, and caused LTCM to underestimate its true level of risk.