Long Term Capital Management Case Analysis

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1.Trades of LTCM

(1) U.S. swap spreads: short Treasury bonds which maturities are nine years or longer, hedged by receiving fixed on interest-rate swaps, at a swap spread of 62 basis points.

(2) IOs: long interest-only strips of Agency-backed pools of fixed-rate residential mortgages, dynamically hedge by receiving fixed on interest-rate swaps.

(3) Differential swap-spread trade in Europe: short long-maturity U.K. government bonds versus receiving fixed on sterling-denominated interest rate swaps (swap spread 62 basis points).

Long German and French government bonds versus paying fixed on French Franc- and Deutchmark-denominated interest-rate swap (swap spread of 23 basis points).

(4) Yield-curve relative-value trades: in the U.K. the Fund was paying fixed in the 20-year sector and the 3-year sector versus receiving fixed in the 7-year sector, with the opposite trade on in Germany.

(5) Equity risk arbitrage: target company’s shares tended to trade at a discount to the consideration offered-usually shares of the acquirer or cash.

(6) Equity pairs trades in Europe:

a. Royal Dutch/Shell Group, whose operating assets were held through two distinct companies representing economically equivalent claims on the operating assets in terms of voting rights, share of profits, and share of dividends.

b. When a company’s non-voting “saving shares” traded at a discount to their fair value relative to the common stock.

c. Holding company often traded at a substantial discount to the market value of their holdings.

(7) Selling stock index volatility: short four-year put and call options on broad stock market indexes, dynamically hedged to be market neutral.

2. The best choice

First, LTCM lost lots of money most due to its widening spreads. It is uncertain to forecast the direction and sizes of the spreads in the future. Because of the high leverage of the Fund, LTCM would face the risk of bankruptcy. Thus, the company should find ways to rescue themselves, it should raise more working capital or decrease the need of working capital to let the company insist longer time until the spreads recover to narrow. It is not a good idea to choose Do nothing.

Second, for the choice of deleveraging the portfolio, the Fund had two alternatives ways. One is to continue the practices over the previous months, decrease the relative-value positions prudently, continue to hold the relative-better convergent trades which is better than previous time. It could reduce the risk of the portfolio and maintain a more liquid of the Fund's position. The firs way is good to the company.

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