LONG TERM CAPITAL MANAGEMENT L.P. A CASE STUDY Essays -

LONG TERM CAPITAL MANAGEMENT L.P. ? A CASE STUDY Rarely if ever has a single firm had as tremendous an impact on international economics as Long Term Capital Management L. P. (LTCM). This report describes the company itself and its investment strategies, with particular attention paid to its international influence and importance. LTCM's activities in the financial world ultimately caused a near-collapse in the entire international financial system. In fact, had the Federal Reserve Bank of New York (FRBNY) not intervened to coordinate a major buyout of LTCM after it sunk into insolvency, the entire financial system could have been seriously jeopardized. Company Profile Set up as a particularly large hedge fund, and comprised of Ph.D. economists and established Wall Street bond traders, LTCM is a very interesting case, as well as an extremely volatile and important fund. Key Members and Their Backgrounds Founded in part by Nobel laureates Robert Merton and Myron Scholes, LTCM based its investment strategies on the mathematical models developed by Scholes, Merton, and Fischer Black. The model itself, commonly known as the "Black-Scholes Options Pricing Model", is famous for two major insights into economic thought. First, the model determines how to eliminate risk as a variable in the option-pricing equation. This was accomplished as a result of the second major insight, which was the idea of using continuous time for option pricing as opposed to second-by-second timing, a most crucial element that Robert Merton borrowed from a Japanese rocket scientist named Ito. Discovering how risk can be eliminated from large-scale investing is obviously an enormous break-through that puts greed in peoples' eyes and gets major investment players fighting for the chance to invest where the model will first be used in practice. Integrating the notion of continuous time into the pricing model elimina ted the problem of an appropriate option price being out-of-date by the time it was calculated. As champions of these powerful tools, Merton and Scholes decided to play the very financial markets that had already been transformed by their insights. The Black-Scholes model is: Value of a call option = P0N(d1) - X [N(d2)] eKRFt Where Po = the current price of a stock X = the exercise (strike) price on the option t = time remaining until expiration of the option KRF = continually compounded risk-free interest rate e = the natural antilog of 1.00 or 2.71828 N(d) = the probability that a standardized, normally distributed random variable will have a value less than or equal to d, essentially the hedge ratios.1 The Black-Scholes pricing model can adjust the value of options to reflect continuously changing stock prices. Black, Scholes and Merton appeared to have made the break-through that could finally bring perfect efficiency to the world's markets. John Meriwether, a wealthy and famous Wall Street bond trader from Soloman Brothers Inc., also played an integral role in the history of the firm. Meriwether left Soloman after having his name too closely associated with a bond-auction fraud scandal orchestrated by one of his colleagues. Meriwether, an old friend of Scholes, brought his expertise in bond markets and bond futures to the firm as its top executive. Also a co-founder, Meriwether brought with him from Soloman several of his former colleagues, who had also left Soloman after the bond fraud scandal in 1992. Hedge Funds and the Uniqueness of LTCM A hedge fund is organized much like a mutual fund (both are private, pooled investment accounts), but with some significant differences. Legally, a hedge fund is distinguishable by the fact that it limits the number of investors to 500 per fund. Also, to qualify to invest in American hedge funds requires a minimum capital amount of US$5 million for individuals, and US$25 million for institutional investors. In the case of LTCM, only those individuals and institutions that the fund's partners sought out were able to invest in the firm. Other things that distinguish hedge from mutual funds are: Hedge fund managers have almost complete autonomy in determining what assets to hold, and are not at all limited in what types of assets they can hold. Hedge funds are allowed to engage in short selling. Hedge funds may use leverage to increase levels of funding and of risk and return. Hedge funds can limit the amount cash injected into and withdrawn