Baroncini Gianni Meloni Valerio Santangelo Giusj

 The history;  Brief description of the case;  Risk factors explaining the case;  Lessons to be learnt (strategy / control / regulation).

 1994-Foundation of Long-Term Capital Management by John Meriwether. Initial equity of $1,3 billion.  1997-Capitalization of $7 billion. Return has dropped to 27%. $2,7 billion returned back to investors.  Early years of returns running close to 40% More aggressive trading strategies LTCM's portfolioOver $100 billion Net asset value$4 billion Swaps position$1.25 trillion notional

 LTCM's strategy was to make convergence trades, finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones.  The main types of trade were: 1-Convergence among U.S., Japan, and European sovereign bonds; 2-Convergence between “on-the-run” and “off-the-run” U.S. government bonds( 30 year treasury bond and a 29 and three quarter year old treasury bond)

 More aggressive strategies:  the fund needed to take highly-leveraged positions to make a significant profit;  the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion;  debt to equity ratio = 25 / 1. -S&P 500 options; -Interest rate swaps(notional value of $1.25 trillion); -Long positions in emerging markets sovereigns, hedged back to dollars; -other derivatives such as equity options.

 The company used complex mathematical models to take advantage of fixed income arbitrage;  Relative value trading;  It was a game, in that LTCM was unregulated, free to operate in any market;  To make high return on capital, high leverage had to be applied;  There was also a big difference in liquidity between long and short positions in which it entered.

17 August 1998: devaluation of the rouble 1 September 1998: special terms 22 September 1998: leverage is even higher 23 September 1998: consortium of leading investment and commercial banks Fourth quarter 1998: substantial write-off as a result of losses flight to quality

1. Russian Sovereign Default As Russia's troubles became deeper and deeper, fixed- income portfolio managers began to shift their assets to more liquid assets 2. Flight to liquidity

What LTCM had failed to account for is that a substantial portion of its balance sheet was exposed to a general change in the "price" of liquidity There is an unhedged exposure to a single risk factor. Flight to liquidity

TradeVolatilityDefaultIlliquidity Long Interest Rate SwapYes Short Equity OptionsYes Long off the run/Short on the run treasuriesYes Long MortgageYes Long Sovereign DebtYes

The Flight to liquidity is a common phenomenon in capital markets crises that it should be built into risk models, either by introducing a new risk factor — liquidity — or by including a flight to liquidity in the stress testing If LTCM have classified its positions as illiquid (referred to long positions in large part) or liquid (the most of its short positions), it would notice that the notional exposure to the liquidity factor is equal to twice its total balance sheet.

Financial models are subject to model risk and parameter risk, and should therefore be stress-tested and tempered with judgement. According to the complex mathematical models used by LTCM, the positions were low risk. Judgement tells us that the key assumption that the models depended on was the high correlation between the long and short positions. Certainly, recent history suggested that correlations between corporate bonds of different credit quality would move together (a correlation of between 90-95% over a 2-year horizon). During Russia's crisis, however, this correlation dropped to 80%. Stress-testing against this lower correlation might have led LTCM to assume less leverage in taking this bet.

LTCM depended on exploiting deviations in market value from fair value. And depended on "patient capital" - shareholders and lenders who believed that what mattered was fair value and not market value. Lenders lost their patience precisely when the funds need them to keep it — in times of market crisis Exploit deviations in market value from fair value generate excellent risk- adjusted returns, but only if held for a long time. Unfortunately the only real source of capital that is patient enough to take fluctuations in market values, especially through crises, is equity capital. We can use Leverage, but not so much

Many of the large dealer banks are exposed to a Russian crisis across many different businesses, and they only became aware of the commonality of these exposures after the LTCM crisis. A systematic risk management process have to be used to discover common linkages ex ante and report or reduce the risk concentration.