CHAPTER 16Long-Term Capital Management

This chapter analyzes the turbulent saga of Long-Term Capital Management (LTCM), a private American fund run very speculatively, although it was initially designated as a hedge fund. This fund began in 1994 and was rescued by the Federal Bank of New York in September 1998.

The problem with this fund, as Jorion (2000) and Shirreff (1999) argue, was that it took highly risky positions and neglected risk management. The fault lies both with the managers of LTCM and their financial backers, who not only lacked vision but also managed their risks ineffectively. The fund managers gave little information to financial backers. The backers did not even know the aggregate makeup of the portfolio.

The risk management of this fund was not regulated, although it should have been reported to the SEC (Securities and Exchange Commission). Consequently, the fund did not have to set aside minimum required capital. In fact, hedge funds are not really constrained in the formation of their portfolios or in their choice of leverage. Shirreff (1999) explains that LTCM managed default risk by assuming that markets were able to absorb all hedging positions within manageable limits. The fund offset a long position in one financial instrument with a short position in a similar instrument or its derivative. The problem is that the fund managers undervalued the limits of these activities. When the limits were reached, the partners insisted that it was too late to ...

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