(from left Myron Scholes, Robert Merton, David Mullins) John Meriwether, a former vice chairman and head of bond trading at Salomon Brothers, founded the hedge fund Long Term Capital Management (LTCM) in 1994. He assembled a group of skilled traders and quants, including David Mullins, Robert Merton, and Myron Scholes. The group started building intricate computer models that could value derivatives and uncover arbitrage possibilities. They designed a business plan around a few key ideas: - The model used to price bonds was flawed - The market overreacted to new information - The market was inefficient in the short-run, but efficient in the long-run LTCM employed a range of financial tools and tactics, such as swaps, options, and futures contracts, to profit on these concepts. To capitalise on market changes, LTCM generally adopted positions that were in opposition to the market. For instance, LTCM may buy a bond if they thought the market was undervaluing it. LTCM would then sell the bond at a higher price and make money from the difference if the market later corrected and the bond's price rose. Some of the strategies LTCM used were: 1. Convergence Trading 2. Merger Arbitrage 3. Capital Structure Arbitrage 4. Equity Swaps LTCM appeared to have built a money machine in its first three years of operation, from 1994 and 1996; return on equity was 20% in 1994, 47% in 1995, and 45% in 1996. The fund outperformed both blue-chip corporate bonds and the US stock market, which was gaining ground at the time. This success is obviously based purely on returns; LTCM's risk-adjusted returns are allegedly not quite as strong. The circumstances in the early years of LTCM's existence were in their favor. But following incidences took place in market which led to downfall of LTCM: 1. The Asian financial crisis in 1997 – The 1997–1998 Asian financial crisis had a big impact on LTCM. The collapse of the Thai baht in July 1997 marked the start of the Thai financial crisis. This set off a chain reaction that spread throughout Southeast Asia, resulting in the devaluation of numerous currencies and the financial instability of numerous nations. Due to its substantial investments in Southeast Asian debt, LTCM was severely impacted by the crisis. A number of LTCM's creditors called in their loans as a result of the crisis, placing great strain on the company. 2. The Russian financial crisis in 1998 – Due to the 1998 Russian financial crisis, which resulted in the default on Russian government bonds and a decline in the value of the Ruble, there was a loss of faith in the Russian economy. As a result, Russian assets were sold off and the value of the currency fell. Because of this, the value of LTCM's portfolio of Russian assets decreased, and the company was compelled to sell additional assets to satisfy margin calls. 3. LTCM's heavy reliance on leverage – LTCM had used large amounts of leverage to increase its profits, but it had also taken on a large amount of risk which resulted in crisis. Midway through 1997, long-term interest rates started to rise, and they did so for more than two years. As a result, LTCM's investments became substantially less valuable, and the company was forced to find cash to pay off its creditors. In September 1998, LTCM attempted to settle with its creditors, but the negotiations failed. At that time, a group of 14 banks and securities companies intervened, spending $3.6 billion to save LTCM. The rescue was necessary to prevent a run on LTCM's assets and to avoid a possible collapse of the financial system. After the LTCM crisis, a number of financial institutions collapsed or were forced to merge. The financial system underwent a number of reforms as a result of the crisis, including the Basel II Accord, which set new, stricter capital requirements for banks. The crisis highlighted the need for investment portfolio diversification and the risks associated with using too much leverage. Thank you.
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