Slide 1: Long Term Capital Management 1
Finance 4280
Slide 2: Game Plan
Players in Investment Management Arbitrage and Finance Basics Long Term Capital Management What Went Wrong?
Slide 3: Positioning Investment Management Organizations
Berkshire Brand Fidelity Capital Vanguard Wellington Neuberger Boutiques
LTCM Hedge Funds Pay for Performance
Pay for Service
Slide 4: Traditional Money Management
Fees
Profits Costs Assets Under Management
Slide 5: Issues in Traditional Asset Management
Organization, Packaging, Distribution Long Only, Relative Return Focus Client Perspective: Style Multiple Products? Scale Fee: % of ASSETS Franchise Value
Slide 6: Hedge Funds
Hedging…..Not Long/Short, Absolute Return Focus Double Alpha Potential Common Fee 1% plus 20% of PROFITS Little if Any Franchise Value Leverage of Various Amounts
Slide 7: Hedge Fund Strategies
Macro** Equity Long/Short Risk Arbitrage** Convertible Arbitrage Fixed Income** Distressed Statistical**
Slide 8: For All Managers:
What is the Right Amount of Assets?
Slide 9: Size Matters! Diseconomies of Scale for Excess Returns
Bid/Ask Spread Market Impact Position Size Transparency of Strategy Positions Large Enough to Matter
Slide 10: A Management Challenge
Opportunities for Alpha Vary Over Time Good Opportunities can become Great Opportunities (OUCH!) Responses: Increase Position? Decrease Position? Funding? How Should One Think About Risk and Leverage?
Slide 11: Financing: Repurchase Agreements
Short Term Sale and Subsequent Repurchase of Securities by Financial Institution Prices on Sale and Repurchase are the Same with Agreed on Rate of Interest Paid to Buyer By the Seller Term of 1 to 90 days
Slide 12: Financing: Interest Rate Swaps
Rate that Investors Must Be Paid in Exchange for Paying LIBOR Rate (Floating) Spreads Generally Trade at a Slight Yield Premium to Government Debt Barometer of Credit Risk (Reflects Premium for Risk of Exposure to Future Rate Fluctuations)
Slide 13: Financing: Interest Rate Swap Agreement
30 yr TSY Return Client LIBOR Return Swap Dealer
Now you can Swap Anything!
Slide 14: Balance Sheet for an Outright Long 10 YR Position
US TSY 10 YR $500 Cash Total Assets $100 $600 Collateralized $500 Financing (Repo) Equity $100 Total Liabilities $600
Slide 15: Balance Sheet for Hedged Position
US TSY 10 YR $500 Collateralized Lending (Reverse Repo) $500 Cash $100 Total Assets $1,100 Collateralized $500 Financing (Repo) US TSY 9.75 YR Sold Short $500 Equity $100 Total Liabilities $1,100
Slide 16: Balance Sheet for an Outright Long 10 YR Position: Swapped
Cash Total Assets $100 $100 Equity Total Liabilities $100 $100
Assets and Liabilities are Off Balance Sheet Cash Flows Reflect Mark to Market Variation
Slide 17: Which Balance Sheet Has More Risk?
6:1 Outright Long 1:1 Swapped 11:1 Hedged Must Move Beyond Leverage Ratios
Slide 18: Value at Risk (VaR)
Potential Loss from Adverse Event in Ordinary Market Environment Statistical Expression of Risk Exposure Based on Expected Returns, Volatilities, and Covariances Key Assumptions?
Slide 19: Assumptions
Continuous Trading Stationary Relationships “Normal Markets” Future Approximates History
Slide 20: LTCM Investor Letter
“Roughly over a long period of time investors may experience a loss of 5% or more about one month in five, and a loss of 10% or more in about one month in 10” Only one month in fifty should it lose at least 20% of its portfolio
Slide 21: What About Fat Tails??
“If the population of price changes is strictly normal, on the average for any stock…an observation more than 5 standard deviations from the mean should be observed about once every 7,000 years. In fact such observations seem to occur about once every three to four years” Eugene Fama
Slide 22: Types of LTCM Trades
Convergence Relative Value Directional
Slide 23: Core Beliefs
Markets Tend Toward Efficiency Over Time Spreads To Narrow As Arbitrage Opportunities Become More Attractive They Attract Capital
Slide 24: Interest Rate Swap Trade
Thesis: Interest swap spreads are narrow so Buy 20yr TSY (repo finance) Enter 20 year Swap Paying Fixed and Receive Floating (LIBOR)
Slide 25: Economics of the Trade
Inflows Treasury Coupon Reverse Repo
Change in Price of 20 year Treasury
Outflows Repo Rate 20 Year Fixed Swap Rate Change in Price of 20 Year Swap
Slide 26: The Numbers
UST 20 YR Yielding 6.77% Repo Rate LIBOR-20bp Swap to Pay Fixed 6.94% (paid Semiannually on Notional $250mm 100% Financed so NO Upfront Capital Libor-Repo Rate averages 20bps
Slide 27: Cash Flow
Assume Repo Rate is Libor-20 Inflow Outflow (UST 20Yld-Repo) - (Swap Rate-libor) = (6.77%-repo) (6.94%-6.77) = (Libor-Repo)-(6.94-6.77) = (Libor-Repo)-Swap Spread = 20-17 = 3bps $75,000/year on $250mm
Slide 28: Analysis
Positive Cost of Carry (3bps) with Lots of Optionality If Swap Spread Widens Long Tsy Position will Appreciate vs Swap for Capital Gain If Swap Spread Narrows Ride Positive Cash Flow Position with Negative Mark to Market or Add
Slide 29: The Bottom Line
Financing Matters…A LOT Trade Works as Long as You can Finance it BUT………. The Amount and Cost of Funding are Determined By other Market Participants
Slide 30: Staying Power
Time Horizon Funding Structure Client Performance Sensitivity Franchise Value
Slide 31: Issues to Ponder
Size Matters How Should One Measure Leverage? What is the Optimal Way to Evaluate Risk?
