What was 'Long-Term Capital Management (LTCM)'

Long-Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize-winning economists and renowned Wall Street traders that nearly collapsed the global financial system in 1998. This was due to LTCM’s high-risk arbitrage trading strategies.

The LTCM fund formed in 1993 and was founded by renowned Salomon Brothers bond trader John Meriwether.

BREAKING DOWN 'Long-Term Capital Management (LTCM)'

LTCM started with just over $1 billion in initial assets and focused on bond trading. The trading strategy of the fund was to make convergence trades, which involve taking advantage of arbitrage between securities. These securities are incorrectly priced, relative to one another, at the time of the trade.

An example of an arbitrage trade would be a change in interest rates not yet adequately reflected in securities prices. This could open opportunities to trade such securities at values, different from what they will soon become, once the new rates have been priced in. LTCM also dealt in interest rate swaps, which involve the exchange of one series of future interest payments for another, based on a specified principal, among two counterparties. Often interest rate swaps consist of changing a fixed rate for a floating rate or vice versa, in order to minimize exposure to general interest rate fluctuations.

Due to the small spread in arbitrage opportunities, LTCM had to leverage itself highly to make money. At the fund’s height in 1998, LTCM had approximately $5 billion in assets, controlled over $100 billion, and had positions, whose total worth was over a $1 trillion. At the time, LTCM also had borrowed greater than $120 billion in assets.

Downfall of Long-Term Capital Management

Due to Long Term Capital Management’s highly leveraged nature, coupled with a financial crisis in Russia (i.e. the default of government bonds), LTCM sustained massive losses and was in danger of defaulting on its own loans. This made it difficult for LTCM to cut its losses in its positions. LTCM held huge positions, totaling roughly 5% of the total global fixed-income market, and had borrowed massive amounts of money to finance these leveraged trades.

If LTCM had gone into default, it would have triggered a global financial crisis due to the massive write-offs its creditors would have had to make. In September 1998, the fund, which continued to sustain losses, was bailed out with the help of the Federal Reserve. Then its creditors took over, and a systematic meltdown of the market was prevented.

RELATED TERMS
  1. Arbitrage

    Arbitrage is the purchase and sale of an asset at the same time ...
  2. Market Arbitrage

    Market arbitrage refers to purchasing and selling the same security ...
  3. Arbitrage Trading Program (ATP)

    An arbitrage trading program (ATP) is a computer program that ...
  4. Currency Arbitrage

    Currency arbitrage is the act of buying and selling currencies ...
  5. Index Arbitrage

    Index arbitrage is a trading strategy that attempts to profit ...
  6. Tax Arbitrage

    Tax arbitrage is the practice of profiting from differences that ...
Related Articles
  1. Investing

    When The Federal Reserve Intervenes (And Why)

    The Federal Reserve doesn't interfere with the economy every time it flounders. Find out more here.
  2. Trading

    Trade Simple, Trade Smart

    Simplicity can be a trader's best friend. Here is a simple day trading strategy which takes advantage of a stock's dynamics.
  3. Investing

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  4. Investing

    How the Sharpe Ratio Can Oversimplify Risk

    When it comes to hedge funds, this measure is not reliable on its own.
  5. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  6. Investing

    How to Invest Like a Hedge Fund

    Hedge funds earn big returns for investors. Find out how they do it and whether you can, too.
  7. Trading

    Quant strategies: Are they for you?

    Quant strategies are designed to exploit inefficiencies and use leverage to make market bets.
  8. Managing Wealth

    Managing interest rate risk

    Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate and directly affects the values of fixed-income securities.
RELATED FAQS
  1. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of opportunity is available to individual retail investors. Read Answer >>
  2. How Do I Use Software to Make Arbitrage Trades?

    Understand the meaning of arbitrage trading, and find out how traders leverage software programs to detect arbitrage trade ... Read Answer >>
  3. What is the difference between arbitrage and speculation?

    Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset ... Read Answer >>
Trading Center