Editing Long-Term Capital Management (section)

=== UBS investment ===

Under prevailing US tax laws, there was a different treatment of long-term capital gains, which were taxed at 20.0 percent, and income, which was taxed at 39.6 percent. The earnings for partners in a hedge fund was taxed at the higher rate applying to income, and LTCM applied its financial engineering expertise to legally transform income into capital gains. It did so by engaging in a transaction with UBS ([[Union Bank of Switzerland]]) that would defer foreign interest income for seven years, thereby being able to earn the more favorable capital gains treatment. LTCM purchased a call option on 1 million of their own shares (valued then at $800 million) for a premium paid to UBS of $300 million. This transaction was completed in three tranches: in June, August, and October 1997. Under the terms of the deal, UBS agreed to reinvest the $300 million premium directly back into LTCM for a minimum of three years. In order to hedge its exposure from being short the call option, UBS also purchased 1 million of LTCM shares. Put-call parity means that being short a call and long the same amount of notional as underlying the call is equivalent to being short a put. So the net effect of the transaction was for UBS to lend $300 million to LTCM at LIBOR+50 and to be short a put on 1 million shares. UBS's own motivation for the trade was to be able to invest in LTCM – a possibility that was not open to investors generally – and to become closer to LTCM as a client. LTCM quickly became the largest client of the hedge fund desk, generating $15 million in fees annually.