Lessons Learned from Long Term Capital Management Essay Example

risk management would correct for these factors. They were not perfectly correcting for the size of these trades because they could sustain their present and anticipated trades on two thirds of their present capital base. LTCM was leveraged 19:1, comparable to the leverage ratios of major banks and securities firms.

Although LTCM did not explicitly attempt to control its leverage ratio, it would often implement trades more efficiently using contractual agreements. LTCM believed that many trading opportunities arose as a result of liquidity-demanding trades by other market participants. LTCM structured its trades so as to require minimal initial outlay of capital. All of the Fund’s contractual agreements were self-financing, and usually LTCM was able to obtain 100% financing.

The 100%-financing and long-short structure of LTCM’s trades had important implications on risk management. First, since a fully-financed position had no explicit equity investment, it was neither possible to work directly with measures such as return on equity nor to measure risk by the notional sizes of the positions. The risk of a long-short position depended entirely on the degree to which the profits on the long position could deviate from the profits on the short position.

On the other hand, a long-short position could become very risky when the risk of one leg was unrelated to the risk of the other. LTCM measured risk in terms of the probability distribution of potential profits and losses and used “value-at-risk”. LTCM’s believed that as pricing discrepancies became more pronounced, trades based on these discrepancies would attract more capital, and thus the downside risk of a trade diminished. I pledge that I have not violated the Booth Honor Code when completing this

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