The sad story of LTCM or why risk management is not like hard science?

IN 1996 And 1997 years hedge fund, controlled Long-Term Capital Management (LTCM) has had an outstanding record of success and has earned an unrivaled track record in financial risk management. However, in August 1998 years, Russia's default on its debts began a chain of unheard-of market movements, which became terrible for LTCM. Some people say, that the moral of this story is, that risk management in the fund was insufficient, although partners (participants) Foundations were experts in the field on Wall Street and had weight in academia..

In this article, the author offers a different interpretation of those events..

Hedge fund collapse, managed by LTCM in 1998 the year was a stunning event. Approximately half of LTCM's partners were PhDs in Finance, most of them were from the Massachusetts Institute of Technology (famous MIT). Two of the partners: Robert Merton and Myron Scholes, received Nobel Prizes for research, which have become cornerstones in the technique of hedging derivative risks. LTCM also included a group of traders with significant experience in the markets and the leader of this "dream team" was trader with an outstanding reputation. However, in just a few months, the fund lost more than 4 billions of dollars and LTCM has been accused of creating a serious threat to the security of the global financial system. Many argued., what this collapse demonstrates, that modern financial risk management technologies do not work. Before, how to address this topic, it will be useful to see the history of LTCM from its inception to its collapse.

Background of LTCM

In the '80s and early '90s, Salomon Brothers made billions of dollars in their own trade.. Most of this profit came from the Bond Arbitration Group., led by John Meriweather. (J. Meriwether). This group was created, to benefit from misrated securities with correlated risks, taking short positions on overvalued securities and long positions on undervalued securities, and hedging those of their risks, which can be hedged.
To understand this approach, suppose, what the band decided, that the yield on a particular US-agency bond was too high compared to U.S. Treasuries. A particular paper has differences from US Treasury bonds in terms of reliability of execution. Therefore, such bonds are traded at a higher yield compared to government bonds.. The group would buy such securities. (agency-bond) and sell short Treasury bonds, hoping, that someday these returns will converge.. This trading technique is called "convergence trading".
Since the government guarantees the redemption of bonds, then the main risk is the interest rate risk. But the fund would have this risk low., because he had a covered position on bonds. This position would bring monetary income., because there would be a difference between a coupon received and a coupon paid on a short position. Further, any narrowing of the spread between agency bond yields and Treasury bonds would create a return on capital..
Ultimately, salomon brothers were embroiled in a scandal., when its employees were caught manipulating Treasury bond auctions. Several of Salomon's top managers left the institution in 1991 year, including Mr. Merivezer (Meriwether). Two years later, he founded Long-Term Capital Management. (LTCM) to manage the Long-Term Capital Portfolio hedge fund. LTCM was organized to follow strategies, used by the Salomon Brothers Arbitration Group. Very quickly, several members of that same group joined LTCM along with future Nobel laureates Robert Merton and Myron Scholes..

A Brief History of LTCM

The fund started trading in February 1994 years and had just the same "star" income for the first two years of work: its investors earned 43% in 1995 year and 41% in 1996 year! In 1997, the fund did much less - the income was 17% per annum. By December 1997 year equity fund has grown to more than 7 billion dollars. LTCM decided, that he does not need such a large amount of capital to manage and returned 2,7 billion dollars to its investors.
By the beginning of 1998, the fund had a capital of about $4,7 billion. Every dollar of this capital was used to increase the fund's total assets., which were approximately $125 billion. The fund had a maximum derivatives position of about $1250 billions at face value. These positions were artificially inflated., because the LTCM strategy was to get out of the derivative position by creating a new position: it was better to create a new position, than to complete existing contracts before they expire. In summer 1998 the fund has had positions in various markets for the year.: Danish mortgages, U.S. Treasury Bonds, Russian T-D-D-Does, U.S. Stocks, mortgage bonds, Latin American bonds, British bonds and US swaps. Under normal circumstances, these positions were highly uncorrelated – the fund had the benefits of diversification., to reduce your risk in addition to hedging positions.
LTCM wanted, so that the volatility of the fund's assets is about 20% relative to the average value of assets. Before April 1998 year this volatility was consistently below target, average 11,5%; asset volatility was consistently low. After that, how the fund's capital was downgraded, its volatility was still significantly lower 20 Percent. With capital in $4,7 billion monthly Value-at-Risk in 5% associated with volatility in 20% how $448 million. In other words, the fund expected to lose the maximum $448 millions within a month.
On Monday, 17 august 1998 of the year, Russia defaults on domestic debt. From that moment began a period of dramatic market events., which led the fund to huge losses. TO 21 august 1998 years his losses amounted to $551 million, mostly by position, which had nothing to do with Russia, but the effect of its default did not directly affect their outcome. Loss to 21 August was more, than 10 times the daily volatility of the fund's assets. Computer tables have calculated the zero probability of such an event, if we proceed from the normal probability distribution.
In the beginning of September 1998 investors of the fund saw, that their investments have fallen by half from January levels, and the fund was rapidly losing capital. Finding 23 September 1998 year under the auspices of the Federal Reserve Bank of New York, heads of 14 leading banks and investment companies decided to invest in LTCM fund $3,65 billion and give it 90% support. It wasn't public money., so the funds raised were not used. Better to say, it was tantamount to prevented bankruptcy.: the fund was restructured to avoid default.
In October 1999 the fund was disbanded. The above-mentioned banks and investment companies made a profit in 10% annual on their investments. The foundation had about 100 investors, who did not participate in the management of the company. Of these 100 investors 88 made a profit on their investments. A typical investor has earned 18% annual on your capital.

Limitations of financial engineering

Initially, LTCM's strategy was based on its ability to manage risk.. To 1998 years the fund showed, that he masterfully copes with this task.. Before that, he had never made a loss for two months in a row and in the worst month the loss was 3,85%. This ability to manage risk allowed the fund to save on managed capital., so investors could earn more. It all looked like a money-producing machine.. And still, despite the successes of modern theory of finance, partners of the fund knew, that the risk cannot be accurately measured and completely controlled, and they were familiar with the limitations of the models, that they used.
There were many partners in LTCM, who were well versed in the pricing of derivatives. Model, developed in the financial economy, very useful, but, like models in other sciences, have their limitations. For example, any trader, mechanically applying the formula for option pricing, would quickly lose your money. Practitioners and academics have developed many improvements to the Black-Scholes formula. However, these developments work well only for a certain period of time and can unexpectedly "collapse". For example, Black-Scholes formula after collapse 1987 makes other mistakes, than before.
Most of the time and for most applications, the limitations of these models don't matter.. However, the problems, that have little impact on organizations, working with low leverage (leverage) can become dramatic for organizations, working with high leverage. Imperfect pricing models could, for example, allow the trader to conclude, that there are opportunities to make a profit in the markets, where there is no one.
Consider the yield spreads between Bonds rated Vaa (bonds with some speculative characteristics) and Treasury bonds. With 1926 the vaa years had a spread in the range from 50 basis points to 800 points. Financiers-academicians, using the characteristics of issuing companies, find it too difficult to explain, how hundreds of basis point spreads can be. In their opinion, there is one explanation for such large spreads.: that these assets are misapprecied and right now it is possible to make almost risk-free profits. Or you can say, that their models overlook something important, in other words, some or even all of the larger spreads are an insurance premium to compensate holders of higher risk bonds from owning them..
Investors, who believe in the theory of "misvalement" of securities, can make big profits on the operation of large spreads, even if the theory is false. But ultimately., even if investors are compensated for the risk they take., their transactions will bring losses.

Too much trust in the "black box"?

Although the problems of LTCM have attracted a lot of public attention, the fall in the cost of capital of leading banks during the last two weeks of August 1998 years made the fund's losses less dramatic against the general background. TO 21 august 1998 of the year, when LTCM lost half a billion dollars, Capital Citycorp (Citicorp) fell more than, than on $2 billion. With 26 August to 4 September market value of Banker Trust assets, Chase Manhattan, Citicorp and J.P. Morgan combined fell on $43 billion or by 29%. I see, that these days there were problems not only with the risk management systems in the LTCM fund. However, it is important to understand, where and how these systems went wrong and turned out to be wrong.
The systems were not mistaken in predicting that., that large losses are impossible. The daily VaR value measures the maximum loss at the reliability level in 99%, that is, with a careful assessment, it would have been achieved only once in 100 days. Risk managers even knew about the existence of some possibility of devaluation and default in Russia or capital outflow from Brazil.
However, risk management systems did not anticipate or be prepared for a "vicious circle" of losses., which manifested itself in, that the fund's positions could not be closed without creating further losses, which in themselves would strengthen the further expansion of the position. The vicious circle had two critical consequences. Firstly, this made one-day VaR measurements untrue, because these measurements are based on assumption, that the position can be closed quickly and at low cost. Secondly, as losses strengthened the expansion of the position, the crisis extended to the fund's unrelated positions, Making, thus, income from various fund positions highly correlated.
At the heart of any risk management system is the prediction of the distribution of income of the portfolio or instrument, whose risks it manages. Under normal conditions, predicting income distribution is much easier.: reality is simply repeated over and over again. However, crisis periods differ sharply.: past observations become useless for predicting the future, volatility often rises sharply and correlations become very high. (Narrow).
All this happened in August 1998.. LTCM's uncorrelated positions suddenly became highly correlated.. In an instant model, based on the fit to past data, steels are not able to reduce risk quickly and at low cost. The fundamental premise of most risk management models is that, that negative events appear by chance - the fact that today there is a large loss does not mean, that there is a high probability of a large loss tomorrow. Unfortunately, in August 1998 Event Year, which risk management models talked about, as unlikely, happened several times a week.

Wrong premises?

Between the time of LTCM creation and 1998 the financial world has changed significantly, partly thanks to LTCM, and partly because of the role of regulators. These changes explain most of that., what happened to LTCM.
LTCM was a financial innovation. Way, with which he earned money, was a real miracle in financial engineering. Unfortunately for the fund's partners, LTCM appeared in the world, where there is competition. Was, that it's hard to keep too good an idea secret. LTCM's "abnormal" profits immediately drew attention to the financial sector., on which the fund worked. This has negatively affected LTCM due to three reasons.. Firstly, immediately created a large number of LTCM action simulators. Secondly, excessive attention began to put pressure on LTCM, so that it continues to show large profits in conditions, when it became impossible. Thirdly, this made the markets less liquid for LTCM's operations.
Imagine the impact of simulators on LTCM strategies. Suppose, what LTCM finds, that the yield on the security is too high. He goes to the market and starts buying this paper., immediately hedging the risk. When imitators do the same thing, paper prices rise, reducing profit opportunities for LTCM, although he was the first to identify them.. The effect of the actions of the simulators immediately lowered the size of the transaction., which LTCM could have done, and reduced his profits from these transactions.
IN 1997 the fund's investors earned a year 17%, which was more than half their income a year earlier.. Traditional positions on spreads in yields have become less profitable. To increase the return on capital, LTCM reduced the fund's capital and started working in the markets, which seemed dubious: Russian T-as-market and secondary stock market.
The fund's partners may have had clear reasons for such actions.. but, these positions had little to do with the strategies they exploited on fixed income instruments., what were the spreads after all?. In these new markets, LTCM could find many other entrants., whose knowledge and skills would at least be equal to the knowledge and skills of the partners and traders of the fund. (For example, LTCM partners have had many scientific publications, but did not make a single transaction on the secondary market.)
LTCM thus opened new positions, results on which were more dependent on each other, than income from its earlier positions. Nevertheless, it is important to pay attention to, that more traditional positions (on fixed income instruments) would bring more losses in August and September 1998 of the year.
However, as far as this can be judged., risk management systems in LTCM failed to notice these changes, until it broke out 1998 year. The shortcomings of the management of the LTCM fund should have been noticed at the beginning of the year., however, there was no clear reason to do so.. It shows, that financial companies-imitators, thinking, that LTCM's past successes will be replicated by them, very little attention paid to safety, when markets have changed against them.
Imitators also had a different influence on LTCM.. They changed the nature of markets., on which he traded. Instead of, to act in isolation, LTCM became the leader at the head of the crowd he controlled.. What the foundation did?, so did the imitators. In this way, the fund began to face poor market conditions, when he had to leave the positions, because he didn't do it alone.. LTCM partially recognized this, using correlations to measure one's own risk. These correlations turned out to be greater than historical values..
Modern theory of finance suggests, that there is competition in the market, so investors or companies can accept prices as given and just react to them.. The fundamental work of Merton and Scholes is based on this premise., as well as all subsequent research in the field of derivatives pricing. And in 1998 year prices, on which LTCM could make trades, depended on that, what the market thought about, what LTCM could or thought to do at these prices. Traditional risk measurement, suggesting, that you can make a deal without significant impact on the price level, thus, has become useless. Short-term risk measurements at LTCM took into account some of these effects., but length, during which this dependence was reflected in the positions of the fund, was a surprise for fund managers. The problem became critical after the impact of market events in August 1998 of the year, after which the fund gained its notoriety.

Regulators and the crisis

LTCM's concerns have been amplified by the influence of regulators., which required banks to use risk management models to stabilize capital. It virtually guaranteed, that sharp increases in volatility would force banks to reduce their trading portfolios. In fact, the effect of the regulators brought a deterioration due to this., that many of their own strategies were complex and forced top management to turn their backs on the problem of increasing macroeconomic uncertainty.. As a result, financial institutions have gone from a stabilizing force to a destabilizing force..
Financial intermediaries make money on the provision of liquidity. As soon as investors want to open a position, financial intermediaries receive a premium for the liquidity provided for this transaction. So you could expect, that in August 1998 financial intermediaries would make a profit on the transfer of positions, that investors had to leave. but, because the capital requirements of intermediaries increased with increasing volatility, financial institutions themselves had to close their positions. Instead of, to provide liquidity, financial intermediaries became its consumers, to this they were persuaded by the requirements of regulatory bodies. As a result, losses in Russia forced them to sell securities in other markets, spreading financial infection.
Providing liquidity in August 1998 should have been very profitable., but market participants, who should be liquidity providers, stayed away from events. Failure to capitalize on such lucrative opportunities is itself a failure of risk management..

Market value

Since its inception, LTCM has taken an extremely conservative approach.. To minimize risk, in which its funding would be drawn, the fund financed itself through fixed-term contracts. No urgent funding, the crisis would be more dramatic and more condensed in time. To minimize counterparty risk, the fund chose derivatives, who were "in the market" every day. In other words, there would be no counterparties, owed LTCM large sums, because daily profits and losses would be settled, as soon as they arose.
In August 1998 of the year, as soon as spreads widened, LTCM suffers market losses: while securities, on which he was "in the long", lost value, other securities, for which he was "short", increased the cost. If LTCM was right about market movements, that would be a temporary problem., which in any case would not have reduced the profitability of his strategies: securities, which he bought were undervalued and this undervaluation would have disappeared by the time the securities were redeemed or even earlier..
LTCM's method of operation on market value securities, combined with a decrease in the market value of its positions, caused the disappearance of his money. Although LTCM correctly required its investors to invest money for the long term to benefit from convergence strategies., the fund got into a situation, when the ruin could have come earlier, than the convergence of yields would be achieved. That could be a good thing., that LTCM was right, that he chose contracts with market value, but one day the strategy, hedge-based failed, because hedgers could no longer work with their liquidity requirements.

How to do better

By and large, the events of August and September 1998 years shown, that risk can be managed. Despite dramatic changes in the markets, no investment company or bank in developed countries has went bankrupt. Derivatives have played a significant role in helping a host of these institutions hedge their risks.. None of the reasons for awarding Merton and Scholes the Nobel Prizes was justified by the events of August and September. 1998 of the year.
At the same time, these events have made clear., that risk management is part of the social sciences. What Makes the Social Sciences Different from Each Other, so it's that, that the object of their study changes over time, in this case, partly due to financial innovation. Understanding these changes and that, how they affect risk, is critical in times of great uncertainty. Risk management is not an exact science, it can't be that., because the past is never repeated in the same form. Future risks cannot be understood without an understanding of economic forces, that affects them — this is not taught in physics faculties or engineering schools. but, understanding risks only matters if that understanding is used to create value.. This means, that risk management cannot be independent of the understanding of profits, which are obtained from taking on such a risk. So regulators, acting under the motto of "risk control", forced financial institutions to refuse to receive possible profits, and thereby made the financial system less stable.

Details of LTCM rise and fall

Long-Term Capital Management (LTCM) was a unique hedge fund. In the first four years of its existence, it consistently showed high returns with low volatility., which no one could repeat. Its collapse in the fall 1998 G. was just as deafening, as well as success. As a result, it was miraculously possible to avoid serious consequences for the global economy., but regulators have not drawn conclusions, which would have prevented the current crisis. Long-Term Capital Management has elevated financial leverage to the level of science. The apogee came at the beginning 1998 G., when with a meager equity capital of the fund ($4,7 billion) his debt reached $125 billion, and off-balance sheet positions on derivatives exceeded $1 trillion. Unlike other derivatives stories, described in this book, the monstrous collapse of LTCM made us think about systemic risk. It seemed, that a "domino effect" could cover the entire global financial system. That's why the Federal Reserve Bank of New York forced 14 large wall street firms, acting as the main creditors of LTCM, support him, by providing a package of financial assistance to $3,6 billion. In this chapter, we will reconstruct the details of the rise and fall of LTCM and reveal the secret to its phenomenal success., which also caused the collapse.

What are hedge funds?

Hedge Funds – Unregulated Investment Funds, controlled aggressively and with great flexibility. In fact, hedge funds are anything., but not "hedged" and safe funds, therefore, they are not suitable for faint-hearted investors. The origin of such an incorrect name is often associated with a small fund in $100 000, created in 1949 G. Alfred Jones. He invested in common stock., "hedged" by short sales (cm. Box A). Like mutual funds hedge funds are financial intermediaries, turning savings into productive investments and seeking to preserve capital and provide high returns to wealthy individuals, pension funds, university funds and other investors, who entrusted them with their money. Unlike mutual funds, which are strictly regulated in terms of investment strategies, the size of the commission of managers and reporting, hedge funds can choose complex strategies, use high leverage and all kinds of derivatives, and engage in short sales. Among other things, they can carry out their activities in almost complete secrecy., with minimum disclosure requirements (cm. Box A). Remuneration, which hedge fund managers pay themselves, unlimited (15–30%), although in some cases remuneration may not be paid, e.g. for losses incurred and not compensated (the so-called "high point principle"). Shortly speaking, "hedge funds are investment pools, who are relatively free in their actions. They are almost unregulable. (till), charge a very high fee, do not necessarily return your money, when you want it, and usually don't inform you that, what they do. Supposed, that they have to make money all the time., and when they fail, investors get their investments back and transfer them to someone else, who has recently shown profit. Every three to four years, they give rise to the "flood of the century."1.

Insert A. Non-trivial hedge fund investment strategies.

According to the Tremont Asset Flows Report for the second quarter 2005 G., more than two-thirds $1 trillion in hedge fund management is invested according to four strategies.

Combining long and short positions in stocks (31%). Foundations, using this strategy, place funds in ordinary shares, fully or partially hedging them with short sales, futures or options to protect returns from market risk.

Event strategies (20%). Foundations, implementing such strategies, earn on the alleged incorrect assessment of the value of securities in the event of significant events, e.g. merges, Acquisitions, reorganizations or bankruptcies.

Macrohedging (10%). Macro hedge funds play leverage at exchange rates, interest rates and commodities based on forecasts of geopolitical trends or macroeconomic events.

Bond arbitrage (8%). Foundations, engaged in arbitration, identify temporary price discrepancies in the bond market and conduct leverage transactions, bringing prices closer together.

Below we will tell you about, how LTCM turned its strategy into a money printing machine.

The Rise of Long-Term Capital Management

The emergence of LTCM is associated with the bond arbitrage department of Salomon Brothers, Which, before the scandal in 1991 G., successfully led by John Meriwether. Being one of the best traders of Salomon Brothers, he became Vice Chairman of the Fixed Income Division, He held this position., until a trader named Paul Moser tried to create a corner in the Treasury bond market, declaring artificially inflated prices. When the U.S. Treasury revealed the plan?, it threatened to ban Salomon Brothers from trading in the Treasury bond market., which almost drove the company to bankruptcy. John Meriweather, in the subordination of which is the trader guilty of the scandal, forced to resign, and the Securities and Exchange Commission fined him for $50 000 for lack of proper control of traders. At the beginning 1994 G. this is John Meriweather and created the LTCM Foundation, eager to continue the bond trading started at Salomon Brothers in a new hedge fund format. Not surprising, that Meriwether brought with him some strong traders from Salomon Brothers, first of all, John Hillibrand and Eric Rosenfeld. To fully equip a stellar team, Meriweser also attracted two prominent financial economists., May- Ron Scholes and Robert Merton, who won the Nobel Prize in Economics in 1997 G. for innovative work on option pricing. Besides, one of the founders of LTCM was David Mullins, former vice chairman of the Federal Reserve Bank (the list of the main founders of LTCM is presented in Table. 1). Combining mathematical models of theorists with market savvy and experience of traders, Merivezer has amplified the magic halo of hedge funds to the limit.

Table 1. LTCM Partners

 

John Meriwether	Former Vice Chairman and Head of Bond Operations at Salomon Brothers; MBA, University of Chicago
Robert Merton	Leading Financial Economist, Nobel Prize winner (1997 G.); Phd, Massachusetts Institute of Technology (MIT); Professor at Harvard Business School
Myron Scholes	Co-author of the Black-Scholes option pricing model, Nobel Prize winner (1997 G.); Phd, University of Chicago; Professor at Stanford University
David Mullins Jr.	Vice Chairman of the Federal Reserve Bank; Doctor of Science MIT; Professor at Harvard University
Eric Rosenfeld	Salomon Brothers Arbitration Group; Doctor of Science MIT; former professor at Harvard Business School
William Krasker	Salomon Brothers Arbitration Group; Doctor of Science MIT; former professor at Harvard Business School
Gregory Hawkins	Salomon Brothers Arbitration Group; Doctor of Science MIT
Larry Hilibrand	Salomon Brothers Arbitration Group; Doctor of Science MIT
James McEntee	Salomon Brothers Bond Trader
Dick Leahy	One of the leaders of Salomon Brothers
Victor Khagani	Salomon Brothers Arbitration Group; Master of Finance, London School of Economics

A unique lineup of Wall Street's leading representatives, academic and government circles proved to be very attractive: he was pecked at by the most respected financial institutions (including Merrill Lynch , UBS and Credit Suisse), a number of foreign governments (including Bank of Italy and Bank of China) and many wealthy individuals. On the first day of its work, LTCM gathered $1,3 billion, having initially $100 million, Nested 16 Founders. The minimum deposit amount was $10 million, investment period (without the right to withdraw funds) was equal to three years. LTCM charged an annual fee 2% from the value of assets and received 25% arrived. Investors were satisfied. In the first four years of operation, LTCM provided exceptionally high profitability.: 19,9% after commissions in 1994 G., 42,8% in 1995 G., 40,8% in 1996 G. And 17,1% in 1997 G. (cm. rice. 1). By the end 1997 G.

thanks to the record performance of the fund, its equity has increased to $7 billion. At this point, Meriweather decided to return to investors. $2,7 billion.

Actually, LTCM was more like a complex bond trading house., and not to the traditional asset management fund of wealthy clients. Michael Lewis, former Salomon Brothers bond trader and bestselling author of "Liar Poker"2 (Liar’s Poker), was struck by the internal layout of LTCM's head office in Greenwich (Connecticut) when visiting the company: "The greenwich space was a miniature replica of the Wall Street Exchange trading floor., but with some differences. Wall, usually located between the trading floor and the analytical department, none. On Wall Street, the trading floor is usually located separately from the analytical department.. Staff, answering calls and conducting operations (traders), are highly paid risk take-takeers. They, who analyzes and explains more complex securities (Analytics), are elite office workers. Also in 1993 G., creating LTCM, Meriwether introduced a new status system. The position of "trader" was canceled. In LTCM any employee, involved in the process of finding solutions for making money in the financial markets, called "strategist""3.

Rice. 1. Schedule LTCM performance

The Alchemy of Finance

LTCM conducted market research to look for price discrepancies or anomalies, which could be used for hedge trading. To put it simply., its trading strategy was based on a "long buy" of assets., which were considered slightly undervalued, and "short selling" of similar assets, which seemed slightly overrated. LTCM then expected the spread to narrow., since price convergence was considered inevitable. Being a "long-term" investor, LTCM was just waiting for it to come.. Such market-neutral, quasi-currency transactions were considered extremely low-risk and were structured to minimize the use of equity through skillful leverage. , According to edowned financial economist and Nobel Prize winner Merton Miller, "They collect coppers all over the world.. But thanks to the large leverage, the result is huge amounts.". Shortly speaking, LTCM's financial alchemy included three components.: 1) Leverage, 2) financing of leverage through repo and 3) risk cost control.

Leverage. The basis of the record profitability of LTCM was the economical use of equity and extremely high leverage., At the beginning 1998 G. LTCM's net worth was slightly less $5 billion at the value of the portfolio of assets in $125 billion. The financial leverage ratio was:

Assets/Equity = $125 billion/$5 billion = 25.

To better understand leverage , analyze LTCM operations without debt financing and with it.

• Let's admit, that LTCM finances its operations solely from its own capital (debt-free). If he invests in securities with profitability 4%, then his profit will be $5 billion x 0,04 = $200 million, and return on assets (ROA) = Profit/Assets = $200 million/$5 billion = 4% will be equal to the return on equity (ROE) = Profit/Equity = $200 million/$5 billion = 4%.
• For comparison, consider a scenario with high leverage., LTCM occupies $120 billion under 3% and invests all assets worth $125 billion under 4%, receiving net profit $125 billion x 0,04 — $120 billion x 0,03 = $1,4 billion.

At the same time, the ROA indicator remains the same., 4%, but ROE rises from 4% to $1,4 billion/$5 billion = 28%.

• Due to the high leverage, the LTCM fund was extremely vulnerable to the slightest decline in the value of the asset portfolio.. For example, if the value of assets fell by 4%, with $125 billion to $120 billion, loss in $5 billion completely carried away the equity capital of LTCM. Leverage is a double-edged sword.

Financing. For large-scale borrowing with very little equity, LTCM chose repo transactions, This is a form of secured lending., which allowed LTCM to obtain short-term loans secured by newly acquired fixed income securities, e.g. Treasury bonds, in the amount of the full value of the pledged assets minus the security margin, equal to 1–2% (adjustment for "risk factor"). Such loans are usually provided at a very low interest rate. (usually, below LIBOR). Let's admit, that percentage was 3%, and LTCM bought additional fixed income securities 4%. Repo transactions are usually concluded for a short period of time, have duration 7, 30 And 90 days and require permanent renewal after these deadlines.

By making such a deal once, LTCM could do this over and over again., up to 25 once. For example, having initial capital $1 billion, LTCM could buy Treasury bonds worth $1 billion, and then mortgage the newly acquired bonds and borrow more $1 billion minus 1% on the "risk factor", to invest at a higher rate in 4%. For this leveraged scheme, the most important condition was the ability of LTCM to continuously borrow at a lower rate., than the return on his investment, and maintain a discount on the "risk factor" at a level not higher 1 % value of pledged securities. In this way, leverage at initial equity $1 billion could reach 25, and the volume of the portfolio of assets — 25 × $1 billion (l — 0,01)25 = $19,446 billion.

However, financing with repo transactions is risky., since the value of the collateral is subject to market risk. In other words, the market value of pledged securities fluctuates depending on changes in interest rates. When interest rates rise, the borrower receives requirements from lenders to make additional collateral.. As LTCM credit transactions were not disclosed, its creditors, mainly commercial banks and brokerage firms, did not know about the true value of the fund's leverage, and if they knew, then considered the security of loans to be sufficient protection.

risk management. LTCM prided itself on its science-based risk management system to protect its high leverage portfolio from adverse market movements.. Finally, his partners were luminaries of financial science. The system was based on the assessment of risk cost, which is a total statistical indicator of the total risk of a portfolio of financial assets. Is considered, that it came about thanks to the CEO of JP Morgan, who asked daily in 16.15 send him one number, reflecting the risk of the bank the next day. That indicator was the risk cost.: "We are at X% sure, that we will not lose more than L dollars in the next N days". In other words, risk cost (V@R) is an estimate of the maximum loss L in dollars on the target horizon (N days) with probability X. It provides a pseudoscientific answer to a complex question.: "How much can we lose??»

To obtain such a simple indicator, it is critical to assess the correlation between different asset classes.. LTCM used V@R data for recent years for its model., trying to avoid the "black swans", like the crisis 1987 G. According to well-known hedge fund manager David Einhorn, "V@R is a very limited tool.. It is relatively useless as a risk management tool and potentially explosive., if it creates a false sense of security among senior executives and controllers. It's like an air cushion., which works properly all the time, but refuses at the time of the accident".

Relative value of convergent trading

The "skate" of LTCM was convergent transactions or transactions with relative value, usually, using fixed income securities, In search of price discrepancies, LTCM conducted an active analysis of the US bond market, he also worked with European and Japanese treasury and mortgage securities., but avoided high-yield bonds and sovereign securities of developing countries, having a high risk of default .

Arbitrage with U.S. Government Bonds. A good example of such a strategy is the quasi-archive between new and old long-term U.S. Treasuries., which LTCM brought to perfection in 1994 G. Newly issued 30-year Treasury bonds are considered new, which are auctioned every six months by the U.S. government to finance the budget deficit.. They are very liquid., ie. easy to sell and buy. LTCM considered them a bit overrated.: investors are always willing to pay a small premium for the most liquid Treasury securities, so-called- "liquidity premium". Unlike them, old 29.5-year Treasury bonds, ie. 30-summer bonds, issued more 6 months ago, are hunted by institutional investors and Asian central banks, including bank of China. They are illiquid, because they are traded infrequently and are quite difficult to find. LTCM believed, that they are a bit underrated. For example, in 1994 G. LTCM found an excessively large spread between 30-year Treasury bonds, released in February 1993 G. (Old), with profitability 7,36% (cm. Box B) and 30-year bonds, released six months later, in August 1993 G. (New), with profitability only 7,24% (cm. Insert C)4.

Spread in 12 basis points correspond to a difference in bond price of about $15. LTCM bought billion dollars cheaper bonds with yields 7,36% and at the same time made a similarly large short sale of more expensive bonds with yields 7,24%. Both types of bonds were identical to each other., except for a slight difference in maturity, partially covered by a small yield differential. So that transactions can bring benefits, the spread should have narrowed, ie. a short sale and/or a long purchase must be profitable. LTCM wasn't going to wait 29,5 years to realize profits, he was counting on a rapid narrowing of the spread. The most likely was a slight decrease in the price of the new bond when it moved to the category of old six months after the issue.. LTCM's investments were reliably protected, because it opened and long (asset), and short (commitment) positions on 30-year Treasury bonds: when long-term interest rates and prices rise or down, and 30-year bond yields were supposed to move in unison.. In the example above, the bond price spread was only $15 on $1000. When the spread is narrowed to $10 the profit on each transaction would be $5 on $1000. To make such operations economically viable, LTCM had to operate with very large volumes. Purchase of bonds on $1 billion would bring profit in $1 billion x 0,005 = $5 million. This is where leverage came to the rescue. , LTCM initially bought bonds, which he then loaned to the bank. This bank transferred these bonds as collateral to LTCM, and that one, in its turn, deposited them with the owner of the bonds, which were borrowed for short sale. In the example, see above, LTCM made a transaction worth $1 billion, to earn $1 billion × 0,005 = $5 million.

Insert C. What is a short sale. To sell bonds in a short, LTCM first borrowed them and immediately sold them.. Upon expiration of the loan term, say, across 90 days, he had to return the bonds to the rightful owner, who originally lent them to LTCM. To do this, LTCM had to buy them through 90 days or earlier at the current price. Suppose, that LTCM holds 30-year bonds with face value $1000 and immediately sells them at the current price $998. Through 90 days (or earlier) he buys the same bonds, to close a short position, but at a different price. Let's admit, that the price is now equal to $995. In this case, LTCM receives a net profit $998 — $995 + $998 (0,04/4) = $13, where the last component is interest on proceeds from a short sale. Proceeds from the short sale are deposited in the account of the bondholder (Lender), who actually receives a secured loan from a short seller. Usually, 1-2% is added to the deposit when the price of bonds sold in short bonds increases.. If 30-year bonds rise in price, e.g. up to $1010, LTCM closes its short position at a loss $998 $1010 + $998 (0,04/4) = -$2. Coupon payments, received by the seller on a short position during its existence, are returned to the bondholder (Creditor).

For the quasi-apartment transaction to be successful, bond prices had to converge.. In the case of widening the spread, there was an unrealized loss when revaluing the position on the market, however, longevity did not appear in vain in the name of LTCM5 – the hedge fund could wait several months for a reversal and narrowing of the spread, to close the deal with profit. so, a rather complex quasi-archive transaction can be represented as follows.

1. Short sale. LTCM borrows new 30-year Treasury bonds on $1 billion. LTCM immediately sells them at the existing price, say, $998 and receives income $998 million, which plus 1% immediately deposited with the owner of the bonds. Short seller gets 4% annual income, pledged to the owner of bonds, however, pays the owner a coupon on the bonds sold.
2. Closing a short position. Six months later, LTCM closes short position, by buying Treasury bonds at the then-current spot price, say, $993. Bonds are returned to the rightful owner. LTCM gets the difference $998 million — $993 million + 0,04/2 X $998 million — $3,62 million = $6,37 million including coupon payment 7,24% to the owner of bonds and receipt 4% annual sales revenue.
3. Long purchase. LTCM buys old 30-year Treasury bonds worth $1 billion at current price $992 behind $992 million. LTCM enters into a re-purchase agreement under 4% with the bank and receives 100% market value of bonds plus 1%.
4. Closing a long position. LTCM sells a long position in bonds at the current price $995, makes a profit $995 million — $992 million = $3 million. Coupon 7,34% annual brings additional $995 million x 0,734/2 = $3,75 million, however, LTCM pays 4% by repo, what constitutes $995 million x 0,004/2 = $1,95 million. Total LTCM gets:

$3 million + $3,75 million — $1,95 million = $4,80 million.

1. LTCM has consistently maintained a hedged position, because long position in bonds = short position in bonds. The hedge fund received in total $11,17 million without taking any risk and without investing capital in the transaction. Interest rate risk was excluded., because both sides of the transaction reacted in the same way (or almost identical) on the rise and fall of interest rates.

Box D. What are interest rate swaps?. LTCM could borrow for five years at a flat rate 5%, and wanted to take advantage of a lower floating rate on commercial paper, Component approx. 3,25%. The interest rate swap gave LTCM the ability to pay floating interest on commercial securities and receive interest payments at a fixed rate in return. 5%. Each payment was calculated based on the impediment amount, say, $1 billion. In fact, after entering the swap, LTCM raised borrowed capital through short-term floating interest rate commercial paper., and its obligations on fixed-rate debt passed to the counterparty at a swap.

Under the terms of the interest swap, the present value of the "fixed leg" must be equal to the present value of the "floating leg", that neither party has a profit or loss on the swap. The cost of a fixed leg is easy to calculate, because. the amount of interest payments from the very beginning is specified in the contract (cm. Box B on bond valuation). However, assessing a floating leg is difficult., since the size of future short-term interest rates is unknown. Forward interest rates can be taken as a market forecast of such rates, determined on the basis of yield curves of bonds with zero coupon. This allows you to estimate the cost of a floating swap leg in the same way., as for fixed payments. Interest rate swaps are mainly used to reduce the cost of financing, and to hedge interest rate risk.

Arbitrage on spreads on interest rate swaps. A variant of the same game on convergence is arbitrage on swap spreads., which brings a small profit with very low risk. LTCM, but, was able to make a significant profit due to leverage. A swap rate is a fixed long-term interest rate, which banks, insurance companies and other institutional investors demand a 6-month LIBOR rate in exchange for payment, Swap spread is the difference between the received/paid fixed rate and the yield of Treasury securities with a similar maturity. Notable, that in developed capital markets, swap rates are usually traded with a small spread to Treasury securities with similar maturities. For example, in the United States in the 1990s. swap spreads held in a narrow corridor of 17-35 basis points with short-term jumps to 85 b. P. during the recession 1990 G. and up to 48 b. P. in April 1998 G.

LTCM conducted convergent trades every time, when the spread shifted to the lower boundary of the corridor or rose to its upper limit, waiting to return to the mean. Trade was based on a simple assumption that, that the interest rate swap repeats (with slightly different interest rates) long position on Treasury securities, financed by a floating rate loan. Opening a long position on Treasury bonds means owning fixed coupon bonds (fixed swap leg), and opening a short position (borrowing) under floating percentage corresponds to floating leg of percentage swap. Let's consider such transactions in more detail6.

Scenario 1 (low swap spread). If the spread between the fixed interest on the swap and the yield of Treasury securities with the same maturity was too low compared to historical data., LTCM bought securities, financed by repo transactions, and was part of a symmetrical percentage swap, paying fixed payments and receiving payments on 6-month LIBOR. The net cash flow from such an transaction was as follows:7:

(Treasury Yield – Flat Swap Rate) + (LIBOR — repo bet) = — Swap spread + [LIBOR (LIBOR — 20 b. P.)] = 20 b. P. — Swap spread,

with that in mind, that the LIBOR rate was usually applied to repo transactions — 20 b. P., compensating losses due to the differential between the lower yield of Treasury securities received and the higher fixed swap rate paid. However, over time., depending on the period of maintenance of this position LTCM, there was a risk of narrowing the positive difference between LIBOR and the repo rate and its insufficiency to cover the negative difference in fixed interest rates. LTCM waited, until the swap spread expands again to the previous equilibrium value, and received income from a positive percentage difference (usually equal to only a few basis points) and capital gains in swap liquidation.

Scenario 2 (high swap spread). If the swap spread has reached the upper limit of its historical range, LTCM was part of a percentage swap, receiving a fixed interest and paying LIBOR, At the same time, he borrowed/sold in short treasury securities., to get a LIBOR repo bet — 40 b. P. Converged transaction, structured according to this scenario, was symmetrical in a scenario with a low swap spread. At the same time, the following net cash flow arose.:

(Fixed Swap Rate – Treasury Yield) + (Reverse repo rate – LIBOR) = Swap spread — 40 b. P.

Profits on both trades were very low., 3–5 b. P., and sometimes it wasn't there at all.. However, such trades provided a valuable opportunity to play on the volatility of the swap spread and were repeatedly multiplied by leverage.. Because the risks of fixed and floating interest rates were perfectly hedged., as long as the spread between LIBOR and the repo rate remained unchanged, LTCM considered such convergent trading to be perfectly in line with its philosophy. (cm. Box E on other convergent trading strategies in European bond markets).

Box E. Extended family of "narrowing spreads". The same price discrepancies were in many foreign bond markets., which are generally inferior in liquidity to the US bond market and are more susceptible to price deviations. In search of yield spreads outside the US market, LTCM had fewer competitors with advanced computer arbitrage programs.. Relying on experience, received on the US bond market, LTCM could conduct similar convergent transactions with foreign Treasury securities and interest rate swaps in the UK., Germany, Italy and Japan. He has also worked in the mortgage bond markets of several European countries., primarily Denmark.

Swap spreads on Italian bonds. LTCM noticed unusually low prices of Italian Treasury securities, whose yield was higher (and not lower) fixed rates on interest rate swaps of Italian companies. The unusual reversal of the swap spread was explained by the market's confidence that, that Italian government bonds carry more risk, than AAA rated Italian corporate bonds. LTCM estimates, the spread was to narrow and widen again as Europe prepared for the introduction of a single currency. (euros) in 1999 G. LTCM bought Italian treasury securities (with higher profitability), financing them with repo transactions, and entered into a swap with the payment of a fixed interest (below Treasury yields) and obtaining LIBOR per lira (above repo rate)8. This allowed LTCM to fix a positive spread without being tied to the direction of interest rate movement., Expecting, that a narrowing of the swap spread will also bring capital gains when closing positions.

Danish mortgage bonds. In the same vein, LTCM has developed an even riskier plan., allowing, that spread in 140 b. P. between 30-year Danish mortgage bonds and 10-year securities of the Danish government will narrow. At the beginning 1998 G. LTCM became the largest investor in the Danish mortgage bond market, forming a position in $8 billion with a simultaneous short sale of the corresponding volume of 10-year government bonds. In summer 1998 G. world capital markets were shaken by the Russian crisis, and spreads soared to record heights. Instead of narrowing down, the spread between Denmark's mortgage and government bonds has widened dramatically since 140 to 200 b.p..

Central Volatility Bank

To the extent, how price divergences in bond markets were reduced due to LTCM's successful and large-scale arbitrage operations, the fund gradually moved to riskier operations, combining directed trading with playing on interest rate convergence. At the beginning 1998 G. LTCM launched large-scale sale of long-term options on major stock indices, including American S&P 500, French CAC 40 and German DAX. Selling options on stock indices is similar to opening short positions, professionals call it "selling volatility" (cm. insert F). After the Asian financial crisis, stock markets were very volatile.. Various disastrous scenarios were considered., with periodic prediction of the "crisis of crises". In an atmosphere of high volatility, the demand of individual investors for instruments has increased significantly, providing protection against stock falls, but leaving the possibility of obtaining income in case of their growth. In response, banks began to offer structured products., usually combining zero coupon bonds, protecting the value of the main investments, with 5-year option колл on stock index. Another offer was a long position in the stock index combined with a 5-year put option on the same index..

Insert F. Volatility and value of options. Volatility is difficult to measure. It is usually measured by the standard deviation of stock index prices in the past.. This approximation allows us to assume, that stock index prices are characterized by a lognormal probability distribution. Historical (Actual) volatility is not always a reliable predictor of the future (Expected) volatility, and implied volatility (withdrawn from the market price of options) reflects market consensus. With increasing volatility, option premiums grow, and vice versa. Implied volatility at any time can be determined based on current option prices based on option price calculation models, since all other parameters are known. However, remember, that option prices are set by traders, including subjective volatility indicators based on historical data in options valuation models.

The meaning of "selling volatility". LTCM actively sold long-term options, because he was convinced, that the implied volatility of these options far exceeds their historical volatility. European Stock Indices, such as French CAC 40 or German DAX, had long-term historical volatility around 15%. In the end 1997 G. and the beginning 1998 G., after the Asian crisis, options on CAC 40 and DAX traded, based on perceived volatility 22%. In other words, these options were expensive and had a high premium. LTCM readily satisfied the active demand of investors for protection against volatility, selling index options, which I considered overvalued. Trade was on a grand scale. According to some observers, its volume reached a quarter of the market.. Soon one of the competitors dubbed LTCM "the central bank of volatility"9. LTCM was convinced, that volatility will decrease and stabilize, and he will be able to buy back the sold options at a lower price (option premiums are closely related to the volatility of the underlying asset, in this case, stock indices). Actually, LTCM predicted volatility based on historical data, in other words, bet on that, that historical data can be a reliable predictor of the future! curious, that LTCM partners, clearly mastered the concept of efficient markets during their doctoral studies, rejected forecasting of market volatility, built into option prices, and preferred historical trends.

These deals proved disastrous for LTCM., when volatility went against the laws of linear extrapolation, underlying forecasts. Actually, LTCM switched to trading strategy, which was significantly different from the original, more prudent convergent trading, based on paired/opposite trades and protected from market movements in one direction or another.

Actually, LTCM did not seek to hold short option positions until maturity and used periodic volatility reductions to take profits.. Speaking of volatility betting, important to understand, that stock indices fluctuated strongly over a short period of time. LTCM believed, that their prices will soon become much more stable, or less volatile. Since the volatility of the underlying indices is closely related to the size of option premiums., with high volatility, options become expensive, and reduced volatility leads to lower premiums. Whatever combinations of options LTCM sells at a high price, he expected to buy them back at a much lower price and make a significant profit.. Really, with the right selection of combinations for certain volatility scenarios, options can bring excellent results.

Mechanisms for selling volatility. Let's consider in more detail the practical aspects of volatility transactions. For playing on volatility, option strategies straddle and strangel are most suitable. LTCM Sells Large Portfolio of Put and Call Options10, drawn up in accordance with these two strategies. The key word here is "sold" (and did not buy). By Selling Options, LTCM received a significant amount of option premiums, Counting, that options will not be exercised, if you keep them until the deadline, or to that, that they can be redeemed at a lower price before that deadline. In case of incorrect calculations and exercise of options, LTCM would incur very large losses.

Straddle. A straddle purchase is the simultaneous purchase of one put option and one call option with the same strike and expiration date. This strategy is particularly attractive to option buyers., when high volatility of stock indices is expected, but it is difficult to predict the direction of the future movement of the stock market. LTCM sold straddles, Believing, that CAC Index Volatility 40 will decrease and stabilize at a lower level. Consider the situation on the market 14 January 1998 G. and straddle sales plan, developed by LTCM.

 

Option sale date:	14.01.98
Assumption:	March Option 1998 G.	on CAC 40
Call call:	FF1900	Stryke puta: FF1900
Call Award:	FF50	Puta Award: FF50

Let's try to accurately recreate the components of the straddle strategy, ie. sale of call and put options on CAC 40 with the same stryk 1900.

Call sale. In exchange for the FF50 cash prize, Received 14 January 1998 G., LTCM committed to deliver one futures to CAC 40 at the price of a build 1900. If the stock index held below the level in 1900, the option would expire without exercise, and LTCM would keep the option premium. But if the index rose above the price of the alert, LTCM would have to put futures on the stock index at the price 1900, buying it at a higher price. The more expensive CAC would be 40, the more losses the fund would suffer. Line 1 on rice. 2 reflects the result of the transaction for the sale of a call option. LTCM makes a profit, equal to the FF50 award, at any index value, not exceeding the price of the build 1900, because in this case the option is not exercised. With the index higher 1900 the profit/loss line is tilted downwards. However, in the interval between 1900 And 1950 (price of a build + bonus) the premium partially covers the loss, caused by the movement of the stock index. When the index value is 1950 lesion, due to its movement, equal to the premium. Here is the break-even point. If the value is higher 1950 LTCM incurs increasing losses.

Sale of puta. In exchange for the FF50 cash prize, LTCM committed to buy CAC. 40 at the price of a build 1900. Line 2 on rice. 2 reflects the result of the transaction for the sale of the put option. At a price, the build is less 1900 the buyer exercises the option and sells the CAC 40 on 1900. On this segment, LTCM bears a cash loss., since he has to buy CAC 40 on 1900 and can only sell it at a lower price. Loss is saved to break-even point 1850 (price of a build - premium), where is the loss, due to the movement of the stock index, equal to the profit in the form of a premium. Outside the price of the meeting 1900 option is not executed, and LTCM keeps the entire award, FF50, for each transaction with the stock index.

Rice. 2. Result of the straddle sale

Straddle Chart. Selling a straddle is a combination of put and coll. On rice. 2 it is displayed by a line 3 as a result of graphical addition11lines 1 for call and line 2 for put. Note the pyramidal top of the straddle on the segment, where LTCM can make a profit (bold solid line). It is also worth noting the break-even points A and B. In between, LTCM makes a profit due to very low volatility, and beyond this segment there is an increasing loss due to increasing volatility. To determine the prices of the index, in which the straddle graph intersects the x-axis (break-even points) you just need to find the amount (or difference) call and puta premiums and build prices,

Break-even point A: S (90) A = Price of a build — (Call Award + Puta Award)

S (90) A = 1900 — (50 + 50) = 1800

Break-even point B: S (90) B = Price of a break + (Call Award + Puta Award)

S (90) B = 1900 + (50 + 50) = 2000.

In this way, with an index lower 1800 or higher 2000, LTCM incurs losses, the size of which can literally be unlimited. And vice versa, within this range at low volatility LTCM makes a profit. The maximum profit could be obtained at the value of the index exactly equal to the price of the meeting., 1900. In this case, none of the options are exercised.. As a result, LTCM does not incur any losses due to the movement of the index and retains the full amount of both premiums., equal to FF100 for each CAC futures 40,

Sale of strange. This is another speculative strategy., associated with volatility and combining the sale of calls and puts. Unlike straddle, it's a combination of puts and calls outside of money with different streaks.. Respectively, such options are cheaper, and the premium for them is lower, than for straddle, composed of puts and calls at their. This strategy is less speculative, than straddle, because it has a wider range, in which the seller can make a profit (rice. 3). Its disadvantage is a smaller size of premiums due to lower risk..

 

Option sale date:	14.01.98
Assumption:	March Option 1998 G.	on CAC 40
Call call:	1950	Stryke puta: 1850
Call Award:	FF40	Puta Award: FF40

First, let's plot the results of the transaction for the sale of the call - line 1 on rice. 3. The price at break-even point is equal to 1990 (price of a build 1950 + FF40 Award). In the same way, let's build a schedule for the sale of puta. The price at break-even point is equal to 1810 (price of a build 1850 - FF40 Award) - Line 2 on rice. 3. Selling a strange is a combination of a call option (line 1) and put option (line 2). Its result reflects the line 3, which is the graphical sum of the lines 1 And 2. Interesting break-even points of the strange, in which the line 3 crosses the horizontal axis (premium equal to option losses).

Rice. 3. The result of the transaction for the sale of the strange

Break-even point A: S (90)A = Stryke puta — (Call Award + Puta Award)

S (90)A = 1850 — (40 + 40) = 1770

Break-even point B: S (90)B = Call Call + (Call Award + Puta Award)

S (90)B = 1950 + (40 + 40) = 2030.

Strange remains profitable in the range between break-even points, 1770 And 2030. The maximum profit arises between the strike prices of put and call options, if none of them are fulfilled. At the same time, LTCM receives the full amount of option premiums, FF40 + FF40 = FF80.

Betting on volatility: strengths and weaknesses. Long-term options are not the subject of active trading, but still require daily revaluation on the market and making additional margins, or security to protect the buyer of the option from default by the seller. Selling Long-Term Options, LTCM immediately received large cash prizes and used them as collateral.. When declining

volatility long-term options were in the money, and LTCM could reduce the amount of cash collateral. And vice versa, with a significant increase in volatility, LTCM should have increased the size of the collateral, because the options were out of the money. The situation of LTCM was complicated by, that his bet on reducing volatility was long-term.. But what happened with short-term volatility fluctuations?? Here LTCM depended on investors, who do not always behave rationally. This was one of the main reasons for the fall of the fund..

Departure from the master plan

Playing on the "convergence" in the bond and options markets became increasingly difficult, therefore LTCM engaged in riskier trading, transferring the "philosophy of convergence" to unexplored territories. Primarily, these included transactions with stock pairs, issued by the same company and listed on different exchanges, as well as risk arbitrage on mergers and acquisitions.

Stock Pairs. LTCM's goal was Royal Dutch/Shell, controlled by two holding companies, listed on the Amsterdam Stock Exchange (Royal Dutch Petroleum N. V.) and the London Stock Exchange (Shell Transport & Trading plc). Alspite the fact that both shares gave equal rights to the operating cash flows of the Royal Dutch/Shell group in terms of profit and dividend distribution, with 1992 G. Royal Dutch shares traded at a 7-12% premium to shares of its British cousin Shell.. Why Investors Preferred One Stock to Another? Apparently, the reason was such factors, as the country of registration, tax status, ability to benefit from international double taxation treaties and no taxes on dividends, held at the source of payment12.

LTCM bought Shell shares on $2 billion and sold in a short the same amount of more expensive shares of Royal Dutch, counting on the convergence of their prices. Such expectations were associated with the upcoming change in UK tax legislation., as a result of which Shell shares became more profitable than Royal Dutch shares for some groups of investors. There were even rumors., that the two types of shares will be merged, once and for all. so, LTCM continued to adhere to the "extended" version of the convergence principle, although the basis for such operations was questionable. Unfortunately, instead of reducing royal dutch petroleum's premium to Shell Transport & Trading has grown to 22%, when in summer 1998 G. financial markets covered by the crisis. LTCM's loss on such paired operations was $286 million, with more than half accounted for Royal Dutch/Shell shares.

Risky arbitrage. LTCM sought to play on uncertainty, Surrounding M&A Closure. After the announcement of such a transaction between the two firms, the price of the purchased firm jumps almost to the announced closing price of the transaction.. Price discrepancies reflect uncertainty, related to obtaining regulatory approval for the transaction. As the completion date approaches, this difference decreases.. At the end of the transaction, which occurs in a few months, and sometimes more than a year later, it disappears completely. LTCM bought temporarily undervalued shares of the absorbed firm and sold short shares of the absorbing company. The risk was that., that the deal could not have taken place. So, LTCM lost $150 million, when Tellabs failed to complete the acquisition of Ciena. LTCM, who made a bet on closing the transaction, bought shares of Ciena, the price of which collapsed 21 august 1998 G. with $56 to $31,25.

Generally, LTCM preferred low-risk transactions, avoiding hostile takeovers or situations with complex regulatory approval procedures. Risk arbitrage is radically different from arbitrage on bond market yield spreads and requires in-depth knowledge of companies, involved in transactions, relevant sectors of the economy, existing antitrust and other legislative problems. Obviously, that LTCM did not have such knowledge. Investment Banks, actively engaged in risky arbitrage, usually create small groups of specialists, but LTCM didn't..

LTCM Fall

In the end 1997 G. LTCM returned to its investors $2,7 billion. It's pretty unusual., but it wasn't the unique hedge fund solution that was because of, that there were fewer and fewer price and arbitrage opportunities in the capital markets. In a sense., LTCM did a great job, finding and eliminating them, thereby increasing the efficiency of the market. IN 1997 G. LTCM yield was only 17% - Well below index S&P, which showed profitability 35%. Besides, hedge funds, before that, played a minor role in the world of investment, became noticeably stronger by the mid-1990s. It was clear, what if they weren't already a "market", their great future was already on the wall street horizon.. LTCM was a victim of its own success, and he was honest with his investors.. Meriweather said so.: "It will not be easy for us to maintain ultra-high returns., which was lucky enough to achieve, therefore, we reduce the size of the fund, to increase the chances of obtaining a yield above the market".

Besides, in 1997 G. Asian financial crisis hit 'Asian tigers' for the first time. Significantly overvalued currencies of several East and Southeast Asian countries, pegged to the US dollar, fell sharply under the onslaught of speculative attacks. In summer 1997 G. Thai Baht, Indonesian rupiah, Philippine peso and Korean won halved or even more. Rapid growth of the Asian economy, largely dependent on massive inflows of foreign capital and speculation with leverage, abruptly stopped, when this capital began to leave the region. Asia is in a period of deep recession. As a result of this large-scale capital outflow in search of safe investments in highly liquid U.S. and European Treasuries., spreads between risk-free Treasury securities and riskier mortgage bonds, investment-rated corporate bonds and junk bonds rose sharply. LTCM, who has always relied on spread convergence, was a loser. Some of his "classical" assumptions, e.g. narrowing spreads of new and old 30-year Treasury bonds, turned out to be wrong. These spreads were followed by creditors' demands for additional collateral., since periodic revaluation of the market showed losses, not profit.

The reversal of capital flows has also increased stock market volatility., contrary to LTCM's assumption that volatility will decrease and return it to a lower historical level. As stated above, LTCM called the "central bank of volatility". The Fund was the largest seller of index options, structured in the form of straddles and stranges. When in summer 1998 G. the instability of Asian stock markets spilled over to Russia and hit all major financial centers, huge short positions of LTCM on long-term options on stock indices, including S&P 500 and CAC 40 , were deeply out of the money. Exchanges at once began to require additional margin,

The situation of the LTCM was complicated by another event., not related to turbulent financial markets. In the spring 2008 G. the merger of Travelers and Citicorp was announced. As part of the deal, Travelers became the owner of Salomon Brothers, whose people were many key specialists of LTCM (cm. tab. 1). Salomon Brothers also arbitrated bonds and copied many convergent trading operations.

LTCM. Travelers CEO Sandy Whale and his deputy Jamie Dimon were suspicious of Salomon Brothers' business model., considering it a hidden form of pseudoscientific speculative game, and soon decided to reduce the size of positions. As a result, many of the unclosed LTCM converged trading transactions on fixed income and interest rate swaps have been hit hard.. TO 17 July's losses began to snowball.: "by the end of the month, LTCM lost about 10%, since Salomon Brothers sold everything, what LTCM held"13. Salomon Brothers opened many of the same positions., like LTCM, therefore, the sale of its illiquid assets only increased the spreads., without contributing to their convergence at all. As a result, in July 1998 G. LTCM has experienced one of the most difficult months, which led to the impairment of the fund's assets by 14%. Ironically, Meriwether outplayed his teacher, Salomon Brothers, but the collapse of the latter eventually caused irreparable damage to LTCM.

A month later, 17 august 1998 G., Russia devalued the ruble and declared a moratorium on the payment of public debt. This default has shaken up global financial markets., since Russian banks and financial companies declared force majeure and ceased to fulfill obligations on derivatives. Their counterparties from Western countries suffered huge losses.. LTCM had a large position in ruble bonds of the Russian Federation (T-D-D-D-). The risks of this position were hedged by a similar volume of sold forwards per ruble, based on assumption, default on Russian bonds (loss of principal) will be compensated by profit from foreign exchange differences on forwards (with ruble depreciation). For example, on 1000 rubles, invested in T-d-d-articles, LTCM concluded the forward for sale 2000 rubles, Expecting, that default on T-d-d-d-d'h? (cost reduction with 1000 to 500) will be compensated by profit from foreign exchange differences in case of depreciation of the ruble by 50%. In case of forward sale of the ruble at R50 = $1 and re-purchase by R100 = $1 profit was R2000 x (1/50 1 /100) X 100 = R2000. This allowed the initial investment to be maintained in dollar terms., as foreign exchange gains on forwards offset a 50% decline in bond values and a 50% depreciation of the ruble. Unfortunately, Russia's default on T-d-banks seriously hit Russian banks and they did not fulfill their obligations under forward contracts, Russian bear destroyed LTCM hedge, and the fund was left with nothing.

As is often the case in financial crises, default caused capital flight into "quality" and "liquidity", further increasing losses, incurred by LTCM after the release of Salomon Brothers, Frightened investors tried to get rid of risky securities and invest in the highest- safer tools. This led to widening spreads.. So, only for one of the main groups of convergent transactions, related to arbitrage between new and old Treasury bonds, a few days after the Russian default, the spread increased from 6 b. P. to 19 b. P. 21 august 1998 G. LTCM lost $550 million — the largest loss of the fund in one operating day. Increased volatility in stock markets has also forced investors to seek protection from depreciation., buying long-term options, the main seller of which was LTCM. Naturally, that option prices have risen sharply, and the fund suffered significant losses (margin requirements) on its portfolio of long-term options on index futures, losing again. 21 September was the second day, when the fund suffered the greatest losses, having lost $500 million. Equity LTCM, which back in April was $4,5 billion, reduced to $1 billion with total portfolio assets of more than $100 billion and the size of off-balance sheet positions on derivatives $1,2 trillion. Leverage jumped to 100:1. The main sources of losses ($3 billion of $4,4 billion) became two directions of trade, in which LTCM considered itself a leader: convergent operations in the bond markets using interest rate swaps and rates on the volatility of stock indices through the sale of options. A breakdown of losses by LTCM activity is given in Table. 2. As a result, from $4,4 billion, lost LTCM, $1,9 billion belonged to the partners of the fund, $700 million — UBS and $1,8 billion to other investors, half of which were European banks. Remarkably, what, since the initial investments were returned to most banks long ago, losses arose on profit, left in the fund. Bankruptcy was just around the corner..

Table 2. LTCM losses by type of transaction

 

Russia and other emerging markets	$430 million
Directed trade in developed countries (including short sale of Japanese bonds)	$371 million
Stock Pairs (including Volkswagen and Shell)	$286 million
Арбитраж с кривыми доходности	$215 million
Акции S&P 500	$203 million
Арбитраж с высокодоходными (бросовыми) bonds	$100 million
Арбитраж на слияниях и поглощениях	Примерно нейтральный результат
Свопы	$1,6 billion
Stock market volatility	$1,3 billion

A source: Lowenstein, R. When the Geniuses Failed: The Rise and Fall of Long Term Capital Management (Random House, 2000), p. 234.

LTCM Rescue

2 September Meriwether wrote to investors: "As you know, the Russian crisis led to a strong increase in the volatility of global markets in August... Unfortunately, the net asset value of the Long Term Capital Management portfolio fell sharply. on 44% in August, and on 52% year to date. We, just like you, shocked by losses of this magnitude, especially against the background of the historical level of volatility of the fund"14.

The letter was direct and specific., but, normally, contained virtually no details and, certainly, did not report on the fund's leverage ratio, which by that time had reached 55:1. It was faxed to all LTCM investors during the day.. One of the investors immediately sent it to the financial news agency Bloomberg., which published it. Actually, LTCM's activities were Wall Street's "Polichinel secret", despite Meriweather's best efforts to keep it a secret. "LTCM traded on a grand scale and trumpeted its talents everywhere.. Now he's like an elephant., hiding from hunters in low grass. Most dealers and large hedge funds knew, that LTCM has no money and will have to sell assets, they were also aware of, what exactly he will sell."15.

After Salomon Brothers and Russia, this was the last straw.. The role of the Good Samaritan is not very popular among financial market players.. Active rumors of LTCM losses only increased these losses., and this caused new rumors and even greater losses.. Has Wall Street turned on a shooting star??

The Federal Reserve Bank of New York called on the largest Wall Street firms to support the fund. 21 September Warren Buffett, in conjunction with Goldman Sachs and AIG, offered to buy LTCM for $4 billion. Such a deal would deprive the fund's partners of all their investments.16. On the same day, LTCM suffered the second largest loss in $500 million. Half of it came from a short position in 5-year options on stock indices.. The fund's equity decreased to $1 billion, and leverage ratio at assets in $100 billion reached 100:1. Traders JP Morgan and UBS hinted to John Meriweser, that losses on LTCM's options portfolio arose due to aggressive AIG bets. The situation was exacerbated by the fact that, that AIG was betting on Warren Buffett's consortium in hopes of getting Meriweather to sell the fund cheaply.. Warren Buffett demanded a response within one hour to his offer to buy.. Meriweather rejected the offer., Stating, that in such a short time he will not have time to consult with partners and will not be able to make a decision.

23 September 1998 G. The Federal Reserve Bank of New York organized a meeting 14 commercial and investment banks, large creditors of LTCM, and received their consent to contribute $3,5 billion in the capital of the fund. Limited partners lost their deposits almost completely: only their property remained 10% recapitalized company. Saving the fund was more like not providing a financial aid package., and "bankruptcy by agreement", at the same time, taxpayers' funds were not involved in recapitalization..

"The saviors actually gained control over the assets of the fund.. However, they hired former LTCM employees to manage the portfolio., under their direct supervision and for high remuneration, to guarantee efficiency. Although the Federal Reserve Bank of New York coordinated the resale, he did not support LTCM financially. Many receivables chose not to contribute security., due to LTCM, and some creditors claimed pre-emptiance rights, to get paid out faster. Without prompt action, undertaken by the Federal Reserve Bank of New York, LTCM would have to file for bankruptcy... If the help was provided, then the plan failed: in fact, LTCM was liquidated..

Nevertheless, the intervention of the federal government confirmed the validity of the saying "too big., to allow him to go bankrupt.", implying, that any major financial institution, the collapse of which could destabilize the global financial system, will be saved one way or another.

There may be a question, Why Big Wall Street Companies Agreed to Support LTCM, at a time when most of them were struggling themselves due to rising losses and declining stock prices.17? If we take into account the huge leverage of the fund and its plight, what were Wall Street's real motives in saving LTCM?? The main reason was the complex risk of many banks., related to LTCM. There was nothing good about the unpaid loans., but the source of the main risk was over-the-counter trillions of dollars in OTC derivatives., entangled like a web of all the key players on Wall Street. LTCM default could cause a domino effect in the financial system, the scale of which could not be estimated due to the opacity of OTC contracts. There is no centralized clearing house for them., nor a margin requirements system with data available to all, which are easy to track. Concluding OVER-the-counter contracts, each party independently assesses the counterparty's risk before the transaction and during its term. But the reason for the financial assistance of LTCM was not only the instinct of self-preservation., but also good old greed. Most of the consortium members were well aware of the fund's transactions., because they often copied them themselves. They were aware of the potential for price increases after the financial markets returned to normal and wanted to "enter" the fund on terms., which a few months ago seemed impossible.

Morality

A lesson for investors: on the importance of disclosure. Investing in hedge funds is not for the faint of heart. Pension funds, University Foundations, billionaires and other investors like them have specialized knowledge and allocate only a limited part of their portfolio for such attractive opportunities.. They do so consciously and at their own peril in search of profitability., exceeding the yield of market indices. The yield of the ultra-market "beta" yield is called the "alpha" yield. But is it worth searching for alpha at the expense of investors' right to access essential information?? Hedge funds protect their trading strategies, revealing a minimum of information. Meriwether's letters to investors were a model of mystery.. Investors had no idea about the leverage ratio in the LTCM model and did not ask complex questions., while the fund brought them super profits.

A Lesson for Hedge Fund Risk Managers : history doesn't always repeat itself. Many LTCM convergent trades relied on stable historical trends. It was supposed, that bond spreads and stock index volatility, temporarily out of established ranges, will inevitably return to normal values. Victor Khagani, well-known trader and strategist of LTCM, working in London, Said: " Everything, what we do, based on experience. And all science is based on experience.. If you do not want to draw conclusions from experience, then, with equal success, you can sit back and do nothing.". Linear Extrapolation – A Sound Approach to Modeling the Future, except for exceptions, occurring once a century. Unfortunately, in the history of financial markets sometimes there are "black swans" - unlikely, but catastrophic events, shaking the world economy.

LTCM relied heavily on the risk value measure (V@R), counting, that it reflects all the risks of the fund. In August 1998 G. V@R was equal to $35 million, with probability 99%, but 21 September 1998 G. the fund lost $550 million. V@R is a very useful indicator of risk when the period is adequate., from which the data for its evaluation are taken. Apparently, LTCM adopted a relatively recent period for the construction of its models and did not take into account the "black swans".

Lesson 1 for hedge fund strategists: be careful with diversification. Actively working in many large capital markets, LTCM mistakenly believed in its diversification. But in reality, most of his operations were just variations on the theme of spread convergence.. In times of crisis, capital flight to quality securities dramatically increases spreads in fixed income markets, It also increases the correlation between spreads., as demand for risky and illiquid securities falls sharply, and they become even more risky and even less liquid.. As a result, their spreads to risk-free government securities are rising in unison..

Lesson 2 for hedge fund strategists: beware of the "axis of evil" leverage-illiquidity. Leverage is dangerous in itself, but coupled with investments in illiquid assets poses a mortal threat. LTCM entered into paired transactions on undervalued and most often illiquid securities with fixed income and similar, but slightly overvalued liquid securities. An example is the old/new 30-year bonds.: LTCM was waiting, that over time their market value will return to fair value., and the gap will narrow or disappear. Obviously, that such a strategy requires "patient" capital, and LTCM could count on the long-term investments of its investors. But the bulk of LTCM's capital was borrowed., and creditors are not always patient, if their customers have high leverage. In times of crisis, when capital seeks refuge in quality and liquid assets, illiquid assets become even more illiquid. If they have to be urgently eliminated, to meet margin requirements, when lenders lose patience, they become even cheaper. In fact, in times of crisis, only the market value matters., very sensitive to liquidity, not fair value. The less liquid a security is, the greater the difference between the two costs. LTCM accepted liquidity risk, since the "long" side of his portfolio was usually formed from illiquid securities.. LTCM was the victim of this vicious circle.. He overlooked liquidity risk., which should have been evaluated and taken into account when building a portfolio.

A Lesson for Hedge Fund Lenders: do not neglect the procedure "due diligence". Wall Street lending to LTCM blindly. The big commercial banks wanted to work with LTCM so badly., that they provided huge loans, without access to critical financial information. One dimension of capitalism is self-interest.. Some of the senior executives of the creditor organizations had investments in LTCM, what may have influenced their judgment in assessing credit risk. Information about the true value of LTCM leverage and the size of its off-balance sheet positions in OTC derivatives could lead many unsuspecting lenders to reconsider the terms of the fund.. Meriwether entered into unprofitable transactions for counterparties and used an aura of mystery around LTCM, to maintain the complete opacity of the fund's operations and to obtain minimal discounts on the risk factor from its creditors. Surprisingly,, but these financial institutions, requiring detailed information from retail customers before issuing consumer loans of several thousand dollars, without question provided billions of unsecured loans to the LTCM fund with its huge leverage.

A Lesson for Regulators: on taming OTC derivatives. Unlike the collapse of Amaranth Advisors, hedge fund, lost $6 billion on gas futures in 2006 G. without serious consequences for financial markets, LTCM losses in $4,6 billion eight years earlier almost bankrupted the global financial system. Although both hedge funds had an excessive appetite for risky speculative operations., the difference between LTCM was the use of over-the-counter derivatives, while Amaranth conducted quasi-exclusive transactions with exchange derivatives: natural gas futures and options.

OTC derivatives are individualized financial contracts between two independent parties, settlements for which are carried out without the participation of a centralized clearing house and which do not provide for the introduction of margin. It is extremely difficult to estimate the volume of open OTC contracts. Against, exchange-traded products are standardized contracts with highly capitalized exchanges, e.g. NYMEX or the Chicago Mercantile Exchange. Counterparty risk under such contracts is eliminated by making margins and double daily revaluation on the market with additional margin requirements if necessary.

Regulators should have drawn serious conclusions from the LTCM incident in 1998 G, when the fund was close to bankruptcy. Uncontrolled web of OTC derivatives, do not require proper collateral or margin, allowed LTCM to open conditional positions for more than a trillion dollars, having a meager equity capital in $4,5 billion.

LTCM's counterparties did not have a clear idea of the real value of its leverage., nor the financial risks it has taken. They also did not insist on obtaining adequate security.. Financial tsunami 2008 G. and the AIG rescue largely repeated the LTCM story of a decade ago., but on a much larger scale. And this time in the case appeared trillions of positions on otC derivatives, first of all, default swaps. Regulators' job is to tame the "monster of over-the-counter derivatives.", by introducing a centralized system of calculations and automated data processing. This will ensure transparency and regulatory authorities receive information about market participants and their transactions., so necessary to prevent price manipulation and fraud. Standardization of contracts will inevitably become part of the reforms, allowing to maintain transparency and reduce counterparty risk, what, in its turn, reduce systemic risk.

Epilogue

After LTCM rescue and infusion $3,7 billion in its equity in September 1998 G., the fund continued to indict for some time, losing more $300 million. However, by the end. 1998 G. he began to recoup the lost, as his partners predicted.. To the middle 1999 G. its return on the equity capital formed after the rescue increased by 14,1% after payment of rewards. 6 July 1999 G. he reverted $300 million to its original investors, whose share in the capital (after salvation) was reduced to 9%. Besides, $1 billion was paid 14 banks participating in the consortium, who bought the fund. Later, in the autumn of the same year, banks have fully returned their funds, and LTCM ceased to exist.

Claims of all creditors were satisfied in full. Investors, which at the end 1997 G. were paid $2,7 billion and who considered themselves deprived compared to LTCM partners, when they were forced to withdraw their investments, received sufficient protection against collapse 1998 G. and average annual yield in 20%. Six months later, Alan Greenspan further liberalized the derivatives market on that basis., there is nothing better than self-regulation of financial markets.

Soon after leaving LTCM, John Meriwether reappeared on the financial scene, creating a new hedge fund, which had his initials in the title: JWM Partners LLC. The fund's strategy largely repeated the strategy of LTCM, but with less leverage, At the peak of success, before the crushing financial crisis 2008 G., JWM Partners managed $2,6 billion and worked very successfully for eight years.

Myron Scholes manages the California-based Platinum Grove Asset with capital in $5 billion.

Robert Merton returns to Harvard Business School, continuing to actively advise leading Wall Street players, primarily JP Morgan Chase.