Overview
This book documents the rise and fall of Long Term Capital Management. A hedge fund that specializes in government arbitrage
LTCM’s trading methodology
- Yield for bonds of the same length of maturity with the different maturity dates issued by the US treasure will tend towards each other over time.
- Bond’s past a specific time frame becomes less liquid hence gets discounted by fund managers
- leverage up to 30X capital to short the over bought bond and long the over sold bond, essentially making the difference with little capital employed
Causes for LTCM’s failure
- becoming overly reliant on their models
- a period of continuous credit spread widening was followed by the Russian government bond default. LTMC continuously doubled down on their position assuming the trend would eventually reverse
- not taking into account that unlikely long tail negative events. When they occur the impact tend to be very large
- Excessive use of leverage
- up to 30X as compared to 20X employed by most hedge funds
- made possible by FOMO of all banks who were eager to profit by extending credit lines
- partners borrowed money from banks using securities they own within the firm as collateral
- The margins of any profitable trading methodology will tend to get eroded overtime as big banks start tapping into the same opportunities
- Stepping beyond their circle of competence and expecting the same methodology to still work with international bonds
- assuming political dynamics overseas (Russia) will be the same as within the US
- banks unloading sections of their portfolio likely to be impacted by LTCM’s position after news of LTCM’s funds and positions they hold further exacerbated their problem
- Winding an extremely large position is extremely difficult
- not enough liquidity
- will negatively impact price
Lessons for LTCM’s failure
- guard against hubris / overconfidence
- be self aware of your circle of confidence and staying within it
- always check for faulty assumptions in your reasoning
- avoid excessive use of leverage
- monitor for long tail events that are emergent by nature
- do not double down on any positions that did not performed up to expectation
- guard information about your trades tightly
- be wary of entering into positions with little liquidity
- If your fund gets into trouble and you owe the bank a small amount of money its your problem, but when it is an extremely large amount of money it becomes their problem