Long Term Capital Management

Overview Long Term Capital Management (LTCM) was a hedge fund founded by John Meriwether in 19941. Meriwether was the former vice-chairman and head of bond trading at investment bank Salomon Brothers. Meriwether put together a high profile team of traders and academics in an attempt to create a fund that would profit from the combination of the academics' quantitative models and the traders' market judgment. Some of the high profile employees brought on were Nobel-prize winning economists Myron Scholes and Robert Merton, as well as David Mullins, a former vice-chairman of the Federal Reserve Board. Many large investment banks and other sophisticated investors eagerly invested $1.3 billion when the fund opened2. LTCM's main strategy was to make convergence trades. These trades involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones. The trades LTCM focused on primarily involved Japanese, U.S., and European sovereign bonds. They also held long positions in emerging market sovereign bonds and hedged these with dollars. Because the differences in values were very small on these convergence trades, the fund needed to take large and highly-leveraged positions in order to make a significant profit3 (Figure 1). LTCM was very successful when it began with an annualized return of over 21% in its first year, 41% in the second year and 43% in the third year. Then, in 1998 it lost $4.6 billion in less than four months following the 1997 Asian financial crisis and 1998 Russian financial crisis. The fund eventually had to be bailed out by the Federal Reserve, with the fund liquidating and dissolving in early 2000. The fund had huge positions of almost 5% of the global fixed income market so financial intervention by the Federal Reserve was necessary to avoid a global financial meltdown4 (Figure 2). On September 23, the Fed organized a bailout of LTCM, encouraging 14 banks to