Ltcm

What happened

LTCM: hedge fund started in 1993. Main traders were John Meriwether (former head of fixed income trading at Saloman Brothers), Robert Merton and Myron Scholes (founders of the Black Scholes theory), David Mullins (former vice chairman of Fed Reserve board). Hedge fund industry then was highly unregulated, with minimal reporting to the SEC. It could make interest rate swaps at the market rate for no initial margin and was able to borrow 100% of the value of any top-grade collateral and with that cash to buy more securities and post them as collateral for further borrowing – no limits to leveraging.

LTCM accepted investments from 80 investors who put up a minimum of $10 million each. The initial equity capitalisation of the firm was $1.3 billion. By 1998, the portfolio under LTCM's control amounted to well over $100 billion, while net asset value stood at some $4 billion; its swaps position was valued at some $1.25 trillion notional, equal to 5% of the entire global market.

Trade strategies: Spread trades and directional trades

Spread trades: 2 types Relative value and convergence trades. Because these differences in values were tiny, the fund needed to take large and highly leveraged positions in order to make a significant profit.

- Relative value: speculative transactions based on belief that spreads will return to their historical average, usually transacted between any two assets that have shown a strong historic correlation and whose yield spreads are outside the normal range. LTCM used interest rate swaps to take positions on the spread between U.S. government bonds and U.S. corporate bonds, between triple-A-rated corporate bonds and junk bonds, between U.S. government bonds and emerging market bonds, as well as on the difference between yields on the government debts of different foreign nations (e.g., Argentina, Brazil, China, Korea, Mexico, Poland, Taiwan, Russia, and Venezuela) Relative-value trades tend to have lower risks than...