TK:
You posted in the other thread that you'd be interested in delving into the technical issues regarding the demise of Long Term Capital Management(LTCM).
Below is part of what you posted:
"Your most important contribution here is the notion of leverage, which is at the root of LTCM's failure. I would urge you to dig deeper into this. Why did the risk management model fail? What role Russia's financial crisis had? Once you have completed these we will get into technical more issues..."TK
RE: LEVERAGE BEING THE ROOT CAUSE OF LTCM'S FAILURE
Leverage was not the root cause of LTCM failure TK---it was a proximate cause---but the root cause of LTCM's failure was the flight to liquidity across the global fixed income markets triggered by the Russian crisis.
TK You said you wanted to discuss more technical issues---let's have a discussion about flight to quality---that results in a liquidity crisis when situations like the Russian crisis arises---we'll use LTCM as an example---they had 125 billion in debt on the balance sheet when the crisis hit---we can discuss market vs fair value and how market values matter for leveraged portfolios like LTCM.
RE: LEVERAGE AGAIN
TK, as you know LTCM's main strategy, which they clearly outlined to their investors was to make CONVERGENCE trade.
Now TK, at the beginning of 1998, LTCM had 125 billion in debt on their balance sheet and 5 billion in equity---that's a 25-1 debt to equity ratio---do you understand why LTCM carried such huge leverage ? Explain in terms of their CONVERGENCE trades.
RE: ROLE RUSSIAN CRISIS PLAYED IN LTCM'S DEMISE
As you are aware, the Russian crisis arose in August 1998 when Russia devalued the Ruble and declared a moratorium on its debt--281 billion rubles = 13.5 billion dollars.
HOW DID THE RUSSIAN CRISIS AFFECT LTCM ?
Again TK, you said you wanted to discuss technical issues--let's have that discussion---there was a massive flight to quality after the Russian crisis---investors flooded out of risky markets---how did this affect LTCM---remember they had 125 billion in debt on their balance sheet---let's discuss liquidity---and liquidity as a risk factor.
RE: WHY DID LTCM'S RISK MANAGEMENT MODEL FAIL ?
I hope you are ready to discuss this topic TK!
* Remember LTCM's main investment strategy was to make convergence trades.
* Regarding risk management, LTCM partners believed on the basis of their complex and sophisticated mathematical and computer models that the long and short portions they held were highly correlated---so they assumed the net risk for them was small.
RE: THE RUSSIAN CRISIS & LTCM
When the Russians defaulted on bonds---LTCM believed it had somewhat hedged its Russian bond position by selling rubbles---in theory if Russia defaulted on its bonds---then the value of the rubble would collapse--and LTCM would make a profit on the foreign exchange market that would offset its loses on the Russian bonds---that was the THEORY.
Now TK, what went wrong---why did the LTCM's theory fail ? Hint: Russian govt prevented further trading in rubble.
BOTTOM LINE:
If you are keen on having that discussion on the technical issues regarding LTCM---let's have a go---take your time---no rush.
Rev(former investment banker and now business owner--last 23 years)
hahahaha
