Rajiv

11-04-07, 08:30 AM

There are lessons to be learned from the LTCM debacle

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Summary of the Nature of LTCM: (http://www.sjsu.edu/faculty/watkins/ltcm.htm)

Long Term Capital Management (LTCM) was a hedge fund located in Greenwich, Connecticut. The founders included two Nobel Prize-winning economists, Myron Scholes and Robert C. Merton. Scholes and Merton, among other things, developed along with the late Fischer Black, the Black-Scholes formula for option pricing. LTCM also included as guiding spirit John Meriwether, a former vice chairman of Salomon Brothers and famous bond trader. David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System was also part of the LTCM team. Also several important arbitrage analysts from Salomon Brothers joined LTCM. Eric Rosenfeld left Harvard University to join LTCM. It was a very elite group.

The idea behind LTCM was quite simple to articulate but not necessarily that easy to implement. LTCM was to look for arbitrage opportunities in markets using computers, massive databases and the insights of top level theorists. These opportunities arose when markets deviated from normal patterns and was likely to re-adjust to the normal patterns. By creating hedged portfolios the risks could be reduced to low levels. According to the model developed by Merton the risk could be reduced to zero, but in practice some of the crucial assumptions of Merton's model did not hold so the risk of the hedged portfolios was not really zero, as subsequent events proved.

Myron Scholes stated the objective of LTCM in a striking image. He said LTCM would function like a giant vacuum cleaner sucking up nickles that everyone else had overlooked.

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<P>In practice LTCM strategy for making money was based up more mundane principles. One of these principles was the power of leverage. This principle can best be expressed by the equation:

<br>r<SUB>equity</SUB> = r<SUB>assets</SUB> + L(r<SUB>assets</SUB> - r<SUB>debt</SUB>) <br>

<p>where r<SUB>equity</SUB> is the rate of return on equity capital, r<SUB>assets</SUB> is the rate of return on overall capital, r<SUB>debt</SUB> is the interest rate on debt and L, the leverage ratio, is the ratio of debt capital to equity capital. The equation shows that the rate of return on overall capital is augmented by an amplified difference between the rate of return on overall capital and the interest rate on debt. If the leverage is high and capital earns a rate of return greater than the interest rate on debt then all is well, but leverage is a two-edged sword. If the rate of return on overall capital falls below the interest rate on debt then high leverage can turn a mildly bad year into a catastrophe.

The dark side to the leverage equation is the equation that says what happens to risk as a result of leverage. Risk can be measured in various ways but the common result is that the equity risk of a leveraged firm is the risk of the unleverage firm multiplied by a factor of (L+1); i.e.,

<br>risk<SUB>equity</SUB> = (L+1)risk<SUB>assets</SUB><br>

<p>This formula works for risk as measured by the standard deviation of the rate of return as in portfolio analysis or risk as measured by the volatility coefficient β as in the Capital Asset Pricing Model. The formula assumes the debt is risk-free.

LTCM was operating with a leverage ratio in the neighborhood of thirty. At that leverage ratio LTCM needed a rate of return on capital that was only about one percent higher than its interest rate on debt to reach impressive levels of above thirty percent.

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Summary of the Nature of LTCM: (http://www.sjsu.edu/faculty/watkins/ltcm.htm)

Long Term Capital Management (LTCM) was a hedge fund located in Greenwich, Connecticut. The founders included two Nobel Prize-winning economists, Myron Scholes and Robert C. Merton. Scholes and Merton, among other things, developed along with the late Fischer Black, the Black-Scholes formula for option pricing. LTCM also included as guiding spirit John Meriwether, a former vice chairman of Salomon Brothers and famous bond trader. David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System was also part of the LTCM team. Also several important arbitrage analysts from Salomon Brothers joined LTCM. Eric Rosenfeld left Harvard University to join LTCM. It was a very elite group.

The idea behind LTCM was quite simple to articulate but not necessarily that easy to implement. LTCM was to look for arbitrage opportunities in markets using computers, massive databases and the insights of top level theorists. These opportunities arose when markets deviated from normal patterns and was likely to re-adjust to the normal patterns. By creating hedged portfolios the risks could be reduced to low levels. According to the model developed by Merton the risk could be reduced to zero, but in practice some of the crucial assumptions of Merton's model did not hold so the risk of the hedged portfolios was not really zero, as subsequent events proved.

Myron Scholes stated the objective of LTCM in a striking image. He said LTCM would function like a giant vacuum cleaner sucking up nickles that everyone else had overlooked.

.

.

.

<P>In practice LTCM strategy for making money was based up more mundane principles. One of these principles was the power of leverage. This principle can best be expressed by the equation:

<br>r<SUB>equity</SUB> = r<SUB>assets</SUB> + L(r<SUB>assets</SUB> - r<SUB>debt</SUB>) <br>

<p>where r<SUB>equity</SUB> is the rate of return on equity capital, r<SUB>assets</SUB> is the rate of return on overall capital, r<SUB>debt</SUB> is the interest rate on debt and L, the leverage ratio, is the ratio of debt capital to equity capital. The equation shows that the rate of return on overall capital is augmented by an amplified difference between the rate of return on overall capital and the interest rate on debt. If the leverage is high and capital earns a rate of return greater than the interest rate on debt then all is well, but leverage is a two-edged sword. If the rate of return on overall capital falls below the interest rate on debt then high leverage can turn a mildly bad year into a catastrophe.

The dark side to the leverage equation is the equation that says what happens to risk as a result of leverage. Risk can be measured in various ways but the common result is that the equity risk of a leveraged firm is the risk of the unleverage firm multiplied by a factor of (L+1); i.e.,

<br>risk<SUB>equity</SUB> = (L+1)risk<SUB>assets</SUB><br>

<p>This formula works for risk as measured by the standard deviation of the rate of return as in portfolio analysis or risk as measured by the volatility coefficient β as in the Capital Asset Pricing Model. The formula assumes the debt is risk-free.

LTCM was operating with a leverage ratio in the neighborhood of thirty. At that leverage ratio LTCM needed a rate of return on capital that was only about one percent higher than its interest rate on debt to reach impressive levels of above thirty percent.