Editing Long-Term Capital Management (section)

== Trading strategies ==
The main strategy was to find pairs of bonds which should have a predictable spread between their prices, and then when this spread widened further to basically place a bet that the two prices would come back towards each other.<ref name="Too Interconnected to Fail?"/>

The core investment strategy of the company was then known as involving [[convergence trading]]: using quantitative models to exploit deviations from fair value in the relationships between liquid securities across nations, and between asset classes (i.e. [[Fed model]]-type strategies). In fixed income the company was involved in US Treasuries, Japanese Government Bonds, UK Gilts, Italian BTPs, and Latin American debt, although their activities were not confined to these markets or to [[government bond]]s.<ref>{{Cite news |last1=Henriques |first1=Diana B. |last2=Kahn |first2=Joseph |date=1998-12-06 |title=BACK FROM THE BRINK; Lessons of a Long, Hot Summer |work=The New York Times |url=https://www.nytimes.com/1998/12/06/business/back-from-the-brink-lessons-of-a-long-hot-summer.html |access-date=2015-08-22 |issn=0362-4331 |archive-date=2021-05-25 |archive-url=https://web.archive.org/web/20210525002620/https://www.nytimes.com/1998/12/06/business/back-from-the-brink-lessons-of-a-long-hot-summer.html |url-status=live }}</ref> LTCM was the brightest star on Wall Street at that time.<ref>{{Cite journal|last=De Goede|first=Marieke|date=2001|title=Discourses of Scientific Finance and the Failure of Long-Term Capital Management|url=http://www.tandfonline.com/doi/full/10.1080/13563460120060580|journal=New Political Economy|language=en|volume=6|issue=2|pages=149–170|doi=10.1080/13563460120060580|s2cid=220355463 |issn=1356-3467}}</ref>

=== List of Major 1998 Trades ===

==== Fixed Income Arbitrage ====
#Short US [[swap spread]]
#Euro Cross-Swap
#Long US mortgages hedged
#Swap curve Japan
#Italian swap spread
#[[Fixed income]] [[Volatility (finance)|volatility]]
#On-the-run/off-the-run spread
#[[Junk bond]] [[arbitrage]]

==== Equity ====
#[[Long/short equity|Short equity]] volatility
#[[Risk arbitrage]]
#Equity relative value

==== Emerging Markets ====
#Long [[emerging market]] sovereigns
#Long emerging market currency
#Long emerging market equity hedged to [[S&P 500]]

==== Other ====
#[[Yield curve]] trades
#Short high-tech stocks
#Convertible arbitrage
#Index arbitrage

=== Fixed income arbitrage ===

Fixed income securities pay a set of coupons at specified dates in the future, and make a defined redemption payment at maturity. Since bonds of similar maturities and the same credit quality are close substitutes for investors, there tends to be a close relationship between their prices (and yields). Whereas it is possible to construct a single set of valuation curves for derivative instruments based on LIBOR-type fixings, it is not possible to do so for government bond securities because every bond has slightly different characteristics. It is therefore necessary to construct a theoretical model of what the relationships between different but closely related fixed income securities should be.

For example, the most recently issued [[United States Treasury security#Treasury bond|treasury bond]] in the US – known as the benchmark – will be more liquid than bonds of similar but slightly shorter maturity that were issued previously. Trading is concentrated in the benchmark bond, and transaction costs are lower for buying or selling it. As a consequence, it tends to trade more expensively than less [[Market liquidity|liquid]] older bonds, but this expensiveness (or richness) tends to have a limited duration, because after a certain time there will be a new benchmark, and trading will shift to this security newly issued by the [[Bureau of the Public Debt|Treasury]]. [[Fixed income arbitrage|One core trade]] in the LTCM strategies was to  purchase the old benchmark – now a 29.75-year bond, and which no longer had a significant premium – and to [[Short selling|sell short]] the newly issued benchmark 30-year, which traded at a premium. Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued. If the coupons of the two bonds were similar, then this trade would create an exposure to changes in the shape of the typically upward sloping [[yield curve]]: a flattening would depress the yields and raise the prices of longer-dated bonds, and raise the yields and depress the prices of shorter-dated bonds. It would therefore tend to create losses by making the 30-year bond that LTCM was short more expensive (and the 29.75-year bond they owned cheaper) even if there had been no change in the true relative valuation of the securities. This exposure to the shape of the yield curve could be managed at a portfolio level, and hedged out by entering a smaller steepener in other similar securities.

=== Leverage and portfolio composition ===

Because the magnitude of discrepancies in valuations in this kind of trade is small (for the benchmark Treasury convergence trade, typically a few basis points), in order to earn significant returns for investors, LTCM used [[Leverage (finance)|leverage]] to create a portfolio that was a significant multiple (varying over time depending on their portfolio composition) of investors' equity in the fund. It was also necessary to access the financing market in order to borrow the securities that they had sold short. In order to maintain their portfolio, LTCM was therefore dependent on the willingness of its counterparties in the government bond (repo) market to continue to finance their portfolio. If the company were unable to extend its financing agreements, then it would be forced to sell the securities it owned and to buy back the securities it was short at market prices, regardless of whether these were favorable from a valuation perspective.

At the beginning of 1998, the firm had equity of $4.7 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a [[debt-to-equity ratio]] of over 25 to 1.<ref>{{Harvnb|Lowenstein|2000|p=191}}</ref> It had [[off-balance sheet]] derivative positions with a notional value of approximately $1.25 trillion, most of which were in [[interest rate derivative]]s such as [[interest rate swap]]s. The fund also invested in other [[derivative (finance)|derivatives]] such as [[stock option|equity options]].

[[John Quiggin|John Quiggin's]] book ''Zombie Economics'' (2010) states, "These derivatives, such as interest rate swaps, were developed with the supposed goal of allowing firms to manage risk on exchange rates and interest rate movements. Instead, they allowed [[speculation]] on an unparalleled scale."<ref name="Zombie Economics, John Quiggin, 2010">[https://books.google.com/books?id=pTgiRDj-uIYC&dq=%22Thanks+to+the+use+of+complex+derivatives%2C+LTCM+turned+an+equity+base+of+less+than+%245+billion%22&pg=PA55 Zombie Economics: How Dead Ideas Still Walk among Us] {{Webarchive|url=https://web.archive.org/web/20230426011551/https://books.google.com/books?id=pTgiRDj-uIYC&dq=%22Thanks+to+the+use+of+complex+derivatives,+LTCM+turned+an+equity+base+of+less+than+$5+billion%22&pg=PA55 |date=2023-04-26 }}, John Quiggin (University of Queensland in Australia), Ch. 2 The Efficient Market Hypothesis, subsection "The Long-Term Capital Management Fiasco" (pages 55-58), Princeton University Press, 2010.</ref>

===Secret and opaque operations===

LTCM was open about its overall strategy, but very secretive about its specific operations, including scattering trades among banks. And in perhaps a disconcerting note, "since Long-Term was flourishing, no one needed to know exactly what they were doing. All they knew was that the profits were coming in as promised," or at least perhaps what should have been a disconcerting note when looked at in hindsight.<ref name="Business Insider" />

Opaqueness may have made even more of a difference and investors may have had even a harder time judging the risk involved when LTCM moved from bond arbitrage into arbitrage involving common stocks and corporate mergers.<ref name="Business Insider" />

=== 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.

=== Diminishing opportunities and broadening of strategies ===

LTCM attempted to create a splinter fund in 1996 called LTCM-X that would invest in even higher risk trades and focus on Latin American markets. LTCM turned to UBS to invest in and write the warrant for this new spin-off company.<ref>{{Harvnb|Lowenstein|2000|pp=95–97}}</ref>

LTCM faced challenges in deploying capital as their capital base grew due to initially strong returns, and as the magnitude of anomalies in market pricing diminished over time. [[James Surowiecki]] concludes that LTCM grew such a large portion of such illiquid markets that there was no diversity in buyers in them, or no buyers at all, so the wisdom of the market did not function and it was impossible to determine a price for its assets (such as Danish bonds in September 1998).<ref>{{Cite book |last=Surowiecki |first=James |title=The wisdom of crowds |publisher=Anchor Books |year=2005 |isbn=9780385721707 |location=New York |pages=240 |chapter=Chapter 11.IV |oclc=61254310}}</ref>

In Q4 1997, a year in which it earned 27%, LTCM returned capital to investors. It also broadened its strategies to include new approaches in markets outside of fixed income: many of these were not market neutral – they were dependent on overall interest rates or stock prices going up (or down) – and they were not traditional convergence trades. By 1998, LTCM had accumulated extremely large positions in areas such as [[risk arbitrage|merger arbitrage]] (betting on differences between a proprietary view of the likelihood of success of mergers and other corporate transactions would be completed and the implied market pricing) and [[S&P 500]] options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 [[Vega (finance)|vega]], which had been in demand by companies seeking to essentially insure equities against future declines.<ref>{{Harvnb|Lowenstein|2000|pp=124–25}}</ref>