(1.) of Long-Term Capital Management” (Journal of
(1.) Whatare LTCM’s main investment strategies? What were the assumptions they made?What are the potential risks?Afterreading “Hedge Funds and the Collapse of Long-Term Capital Management” (Journalof Economic Perspectives, 1999), it was clear that LongTerm Capital Management hadseveral different investment strategies that were the major reason for itssurvival. One of the many techniques used in Long-Term Capital Management was thedecision to have a long investment in bonds that were undervalued and lowinvestment in some bonds that were overvalued. The management also decided topurchase high yielding which meant that less liquid bonds such as the Danishmortgaged backed securities and those bonds issued by upcoming markets.
It alsosold low yielding, more liquid bonds like the United States government’s bonds.(Edwards,1999)Long-TermCapital Management assumed that returns spread between both high and low riskbonds were very wide. An example of this assumption was the spread ofhigh-yield corporate bonds throughout the United States. After assuming thespread of these high-yield corporate bonds, Long-Term Capital Management decidedto borrow money from some banks so that they could try to enter into the bondmarket. This decision created a significant risk for Long-Term Capital Management,because it was not likely that the yield spread would change in contrast to theexpectation that the firm would lose a lot of its money. (Edwards,1999).
(2.)Whywere they so successful in the beginning years?Thereason that hedge funds were able to have success in the early years was mainlybecause of the decisions it made in regards to market investment. Anotherreason for the early success was because the funds had impressive Sharpe ratios,which is the ratio of excess return on investment. This ratio is measured whenthe returns are over and above the less risky treasury bills to the volatilenature of that investment.
In the beginning Long-Term Capital Management’s portfoliosof hedge funds had Sharpe ratios of 1.58 and 1.47 which was greater than theprevious periods. The successful performance of this investment in the beginningperiod shows that the hypothesis about the performance portfolios fronted bythe firm was a positive forecast.(3.) What were the external factors thattriggered the problems? How did they try to address the problem?Thefinancial trouble that Long-Term Capital Management faced was due to the other factorsoutside the firm’s control.
One of these factors was the fall of the Asianfinancial services. In the spring of 1998, the Asian financial service fell,and it was expected that this would have very negative effects on the up and comingmarkets. After that happened, several financial institutions tried to find a way to get rid of the riskynon-liquid bonds. Buyers began to decrease, and the returns struggled. Thesetwo events had a great impact on the activities of Long-Term Capital Managementbecause it was heavily involved in the bonds market, so it relied on theactivities of third party players (Edwards, 1999). The fall of the bond marketmade the situation even worse for Long-Term Capital Management due to the factthat their main investments were in selling and purchasing high-risk liquid andnon-liquid bonds.
Long-Term Capital Management tried to solve this by asking forhelp from the federal reserve bank of New York. The federal bank of New York wasable to help save the company by giving different incentives including loans(Edwards,1999).(4.) How did Fed intervene? Any majorregulation changes following its collapse.Thefederal bank of New York made several meetings with the management of the Long-TermCapital Management, where they were able to help save the firm. Long-Term CapitalManagement was given some loans to save some assets that were close to declining.The decision of the Fed to intervene with problems that Long-TermCapital Management had, was a very crucial move for the firm.
Because ofthe saving of Long-Term Capital Management it lead to the lowering of the magnitudeof market knowledge. The biggest change was the instruction that the fed gaveto banks that allowed them to freely lend money to firms that were not able tofinance their own activities (Edwards, 1999).
