Long-Term Capital Management

Long-Term Capital Management (LTCM) was founded in 1994 by a group of Solomon Brothers bond traders. The group was headed by John Meriwether and included Nobel-Prize winners Myron Scholes and Robert Merton. The fund enjoyed tremendous early success, averaging annual returns of over 40%. LTCM started with $1 billion in assets and by 1997 had over $7 billion in assets under management. In 1998, the fund had $5 billion in equity with which it controlled over $125 billion dollars worth of assets, due to leverage. Its off-balance sheet positions included an array of swaps, options, repurchase (repo) agreements, and other derivatives which added up to over $1 trillion. LTCM was able to leverage its balance sheet through the use of repo agreements. LTCM adopted a convergence-arbitrage strategy, with the goal of taking advantage of small differences in prices between similar securities. This strategy only allows for small gains in profits to take place, so in order to maximize their returns, LTCM had to use a lot of leverage.

LTCM had primarily been betting on convergence in the European Monetary System that had allowed the fund to register above average returns, but by 1997 the returns had fallen and were being outperformed by the major stock market indices. LTMC reacted by increasing their leverage even more to boost their returns which increased their overall risk. When Russia announced it was defaulting on its debt, LTCM registered massive losses. LTCM’s only option was to liquidate its fund. Due to the fund’s size, the Federal Reserve and the LTCM’s creditors were forced to bail them out, out of fear that the liquidation of its portfolio would cause a global financial crisis.

LTCM’s measured its risk primarily through the metric, Value at Risk (VAR). Value at Risk measures the worst loss that can happen under market conditions over a specified horizon at a specified confidence level. When constructing its portfolio, LTCM aimed at having a risk level no...