LTCM, a hedge fund founded in early 1994, generated stellar returns in its first years of operations: 43% in 1995 and 41% in 1996. With positions in equity, fixed income, and derivatives markets all around the globe, LTCM had grown enormously. At the beginning of 1998, it had a $125 billion of assets on $4.7 billion of equity capital, yielding a leverage of $28 to $1. Although this balance sheet leverage was in line with other large investment banks, it underestimated the true leverage by overlooking the economic leverage in LTCM’s positions. For example LTCM’s positions represented a notional principal in excess of $1 trillion. The astronomical use of leverage was possible because financial institutions often waived margin requirements based on the reputation of the principals, freeing up capital to take on more leverage. Most LTCM investment strategies can be classified as relative value, credit spreads and equity volatility. The relative value strategy involved arbitraging price difference among similar securities and profiting when the prices converged. One benefit of this converging strategy is that being long and short similar securities hedges risk exposures and reduce volatility LTCM believed that, although yield differences between risky and riskless fixed income instruments varied over time, the risk premium or credit spread tended to revert to average historical levels. Noticing that credit spreads were historically high, they entered into mortgage spreads and international high yield bond spreads intending to profit when the spreads shrank to more typical historical levels Similarly, their equity volatility strategy assumes that volatility on equity options tend to revert to long term average levels. When volatility implied by equity options was abnormally high, LTCM sold volatility until it regressed to normal levels.

Required: Discuss the factors that led to the collapse of Long Term Capital management.