are LTCM’s main investment strategies? What were the assumptions they made?
What are the potential risks?
reading “Hedge Funds and the Collapse of Long-Term Capital Management” (Journal
of Economic Perspectives, 1999), it was clear that LongTerm Capital Management had
several different investment strategies that were the major reason for its
survival. One of the many techniques used in Long-Term Capital Management was the
decision to have a long investment in bonds that were undervalued and low
investment in some bonds that were overvalued. The management also decided to
purchase high yielding which meant that less liquid bonds such as the Danish
mortgaged backed securities and those bonds issued by upcoming markets. It also
sold low yielding, more liquid bonds like the United States government’s bonds.
Capital Management assumed that returns spread between both high and low risk
bonds were very wide. An example of this assumption was the spread of
high-yield corporate bonds throughout the United States. After assuming the
spread of these high-yield corporate bonds, Long-Term Capital Management decided
to borrow money from some banks so that they could try to enter into the bond
market. This decision created a significant risk for Long-Term Capital Management,
because it was not likely that the yield spread would change in contrast to the
expectation that the firm would lose a lot of its money. (Edwards,
were they so successful in the beginning years?
reason that hedge funds were able to have success in the early years was mainly
because of the decisions it made in regards to market investment. Another
reason for the early success was because the funds had impressive Sharpe ratios,
which is the ratio of excess return on investment. This ratio is measured when
the returns are over and above the less risky treasury bills to the volatile
nature of that investment. In the beginning Long-Term Capital Management’s portfolios
of hedge funds had Sharpe ratios of 1.58 and 1.47 which was greater than the
previous periods. The successful performance of this investment in the beginning
period shows that the hypothesis about the performance portfolios fronted by
the firm was a positive forecast.
(3.) What were the external factors that
triggered the problems? How did they try to address the problem?
financial trouble that Long-Term Capital Management faced was due to the other factors
outside the firm’s control. One of these factors was the fall of the Asian
financial services. In the spring of 1998, the Asian financial service fell,
and it was expected that this would have very negative effects on the up and coming
markets. After that happened, several financial institutions tried to find a way to get rid of the risky
non-liquid bonds. Buyers began to decrease, and the returns struggled. These
two events had a great impact on the activities of Long-Term Capital Management
because it was heavily involved in the bonds market, so it relied on the
activities of third party players (Edwards, 1999). The fall of the bond market
made the situation even worse for Long-Term Capital Management due to the fact
that their main investments were in selling and purchasing high-risk liquid and
non-liquid bonds. Long-Term Capital Management tried to solve this by asking for
help from the federal reserve bank of New York. The federal bank of New York was
able to help save the company by giving different incentives including loans
(4.) How did Fed intervene? Any major
regulation changes following its collapse.
federal bank of New York made several meetings with the management of the Long-Term
Capital Management, where they were able to help save the firm. Long-Term Capital
Management was given some loans to save some assets that were close to declining.
The decision of the Fed to intervene with problems that Long-Term
Capital Management had, was a very crucial move for the firm. Because of
the saving of Long-Term Capital Management it lead to the lowering of the magnitude
of market knowledge. The biggest change was the instruction that the fed gave
to banks that allowed them to freely lend money to firms that were not able to
finance their own activities (Edwards, 1999).