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Long Term Capital Management

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Ploy Chantakul

on 28 August 2015

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Transcript of Long Term Capital Management

Background and Facts

Risk management issues

Comparing and Contrasting

Lesson learned from the case

Long Term Capital Management
Tatsawan Chantakul
Chenhui Guo
Xinchi Jiang
Yang Li

One of the most highly leveraged hedge funds in history and founded in Greenwich 1994

Board of directors: John W. Meriwether, Myron S. Scholes and Robert C. Merton

Core business :hedge funds transactions

Core strategy: relative-value; taking advantage of price differences among related securities.

Core assumption: the future will be like the past.
Risk management evaluation
Risk management evaluation
Risk management
Measuring the risk correctly
Diversify the portfolio to manage the risk properly
Liquid position(liquidity, credit and volatility)

Enough capital to survive
Lessons for financial regulators
Limited the ability of regulators to identify the systemic risk that LTCM posed

Enhancing the quality of reporting financial information by financial institutions, especially hedge funds.

Lessons learned
Carefully implement the VAR model

Should not only use recent history to measure risk

The need for stress-test

Proscriptive action

August,LTCM approached Buffett for help
Federal reserve and 14 banks stepped in with $3.65 billion capital for LTCM to be kept going
Consequence of the case
Requirements for more regulation
Consequence of the case
Consequence of the case
The Federal Reserve cannot allow huge institutions to collapse because it may lead to the failure of the financial system.
Consequence of the case
The most damaging consequence of the LTCM episode is the harm done by the perception that Federal Reserve policymakers do not really have the faith to take their own medicine.
Consequences of the case
An inter agency study to look at ways of making the activities of offshore hedge funds more transparent

difficult to regulate because of its small physical presence
Massive Extension of Federal Reserve Responsibilities

no regulatory authority over hedge funds
bail out-- Fed accepted responsibility for the safety of U.S. hedge funds

Problem becomes deeper
The return of Too Big to Fail
Damage to the Moral Authority of the Federal Reserve
Would you choose to bail out the LTCM at that situation?
...Thank you...

Any question?
Operational risk
Financial risk
1. Over-leverage
Risk identification
1. Failure to aware of Market price dynamics

2. Over-reliance on "VAR" method
After the announcement of Russia's bond restructuring...
Debt : $100 billion
Equity : $2.3 billion
Leverage ratio : 43:1
= more capital needed
2. Lack of equity capital
- All highest-return investment but different markets
3. Mistaken diversification method
- "What will be the worst case" analysis
- Based on the historical data
- Estimated loss $2.3 billion/Actual $4.4 billion
Environmental risk
Net asset value drop by 16%
In comparison to Ernst & Young
High financial leverage
LTCM Returns
"Hedge fund"
Relative-value strategy
The goal of absolute sense/over the benchmark
Derivatives and Leverage
Not regulated by SEC
Slightly controlled by financial regulations
Not publicly advertised
Free decision-making by managers
Risk management evaluation
1. No plan for potential risks
Increasingly leverage
Too emphasis on "VAR model" and "Black and Scholes model"
Failure to examine all the possible scenarios
Risk management
2. Poor performance on managing crisis
Invested too much bonds on new developing financial market(Asia/ Russia/Mexico)
Sold German and American bonds
3.Failure to recognize the crisis
Asian financial crisis
Downturn in mortgage-backed security market
Salomon Brothers was quietly closing down its proprietary trading business
Model failure
4. Inability to solve the crisis
Major wrong decision made
a. About Leverage
b. About Liquidity
No action to correct the error (e.g. raise fresh capital)
Failure to communicate with the related stakeholders
1. A downturn in the mortgage-backed securities market in May, 1998
2. Russia's announcement of bond restructuring in August, 1998
Increase the price of Treasury bond and vice versa in the lower quality bonds
Loss of $550 million
"Once in several billion times the life of the universe"
Crockford hypothesis
Severity rises - Frequency(possibility) falls
low probability of occurrence in business planning
Dembo's Concept of Regret
"Outcomes are not symmetry"
Be ready in response to both possible positive and negative outcomes
LTCM failed to do so
improvement on risk management
revisit the VAR model
use multiple evaluation model

Class question
beyond the funds 's capacity to anticipate
firm cannot manage the risks appropriately
Full transcript