Lessons Learned from Long Term Capital Management
Lessons Learned From Long Term Capital Management
LTCM was selling liquidity as their fund structure was more similar to an investment bank than a typical hedge fund. When investors or issuers need to change their positions or risk exposure, they would go to an investment bank or dealer to buy or sell securities. In turn, the dealer would utilize the capital markets to offload the exposure. LTCM was often on the other side of these transactions, in some sense, wholesaling risk to the investment bank. I think that LTCM was in some sense insuring the financial markets because they required specific marked to market contractual agreements with their counterparties similar to an exchange but structured differently. This created a less costly version of margin maintenance for both parties involved.
In regards to risk management, the challenge of holding large positions for LTCM was market liquidity. The firm had experienced many instances in which prices moved against them as they attempted to exit out of a losing position, which suggested that the firm’s trades were having a large market impact. LCTM also realized that the gains that could be obtained by the changes in response to relative value positions were limited by market liquidity. Therefore, due to position size, gains were reduced on some positions and losses were exaggerated on other positions. Risk management could correct for these factors by correctly valuing both the economic risk of the trades (measured by potential marked to market losses in the Fund’s NAV) and assessing the fund’s potential liquidity needs. LCTM was accounting for the size of their positions by estimating their liquidity needs in an adverse funding scenario. This type of risk management would correct for these factors. They were not perfectly correcting for the size of these trades because they could sustain their present and anticipated trades on two thirds of their present capital base.
LTCM was leveraged 19:1, comparable
LTCM was selling liquidity as their fund structure was more similar to an investment bank than a typical hedge fund. When investors or issuers need to change their positions or risk exposure, they would go to an investment bank or dealer to buy or sell securities. In turn, the dealer would utilize the capital markets to offload the exposure. LTCM was often on the other side of these transactions, in some sense, wholesaling risk to the investment bank. I think that LTCM was in some sense insuring the financial markets because they required specific marked to market contractual agreements with their counterparties similar to an exchange but structured differently. This created a less costly version of margin maintenance for both parties involved.
In regards to risk management, the challenge of holding large positions for LTCM was market liquidity. The firm had experienced many instances in which prices moved against them as they attempted to exit out of a losing position, which suggested that the firm’s trades were having a large market impact. LCTM also realized that the gains that could be obtained by the changes in response to relative value positions were limited by market liquidity. Therefore, due to position size, gains were reduced on some positions and losses were exaggerated on other positions. Risk management could correct for these factors by correctly valuing both the economic risk of the trades (measured by potential marked to market losses in the Fund’s NAV) and assessing the fund’s potential liquidity needs. LCTM was accounting for the size of their positions by estimating their liquidity needs in an adverse funding scenario. This type of risk management would correct for these factors. They were not perfectly correcting for the size of these trades because they could sustain their present and anticipated trades on two thirds of their present capital base.
LTCM was leveraged 19:1, comparable