Editing Long-Term Capital Management (section)

=== 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>