Long Term Capital Management

Value Proposition: LTCM engaged in trading strategies that would exploit market pricing discrepancies, and generally structured trades to exploit the option value inherent in excess spread volatility. Using convergence and relative value strategies, LTCM took long and offsetting short positions in instruments that were close substitutes. Spread between the on-the-run and off-the-run Treasury bonds is one example. If the spread is wide, LTCM would purchase the off-the-run bond, and sell short the more expensive and more liquid on-the-run bond. With attractive financing rates, this position would profit if held to maturity. The position would also make significant profits as the difference in the value of the bonds narrowed when a new bond was issued

Financing: The Fund was structured as an off-shore limited partnership, and investors invested in the Fund through a series of investment vehicles. The partnership structure avoided double taxation while still providing investors with limited liability. LTCM received a base fee of 1.5% per quarter of the NAV, plus an incentive fee equal to 25% of the yearly increase in the Fund’s NAV. By September 1997, the Fund’s net capital stood at $6.7 billion, with principals’ share of its capital at $1.6 billion. Outside of LTCM’s principals and employees, most significant investors were commercial banks and other financial institutions.

LTCM obtained long-term equity capital by subjecting investors initially to a three-year lock-up. The firm obtained $230 million of unsecured term loans with maturities of about three years, and negotiated a $700 million unsecured revolving line of credit from a syndicate of commercial banks. Finally, LCTM financed most of the Fund’s securities positions through the use of term repos with 6-12 months maturities, in order to guard against being forced to liquidate its positions quickly due to possible disruption in the financing markets.

Leverage: Institutionally, leverage was defined as the...