Long Term Capital Management Hbs Case Questions

Long Term Capital Management HBS Case Questions

1. Analyze different trading strategies of LTCM

Answer:

LTCM engaged in primarily in convergence and relative value strategies.

Relative value strategy : It is a spread trade and it involves two assets whose prices or yields tend to converge with time . it involves long and short positions of similar instruments. This often happens when a company has more than one holding company listed in different markets (e.g. Royal Dutch and Shell). The price divergence in these different markets creates profitability. Although the price may not completely converge, but the premium tends to narrow over time.

Convergence Strategy: In case of convergence strategy the two asset prices or yields must converge. when there was a specifiable future date(usually medium-term fixed maturities) by which convergence of offsetting short and long positions in similar instruments should occur. An example would be a strategy consists of buying off-the-run high yield bonds and shorting on-the-run low yield bonds. Once the newly issued on-the-run bonds become off-the run, the yields on the two bonds converge and LTCM makes a profit. This is a simple strategy and not necessarily a risky trade since it is very likely that the yields will converge once the on-the-run bonds become off-the-run. Since the yield spread between on- and off-the-run bonds is very narrow, it is possible to make significant profits only with large positions.

It also involved in directional trades, which were un-hedged positions like long on French Government bonds. Their trading opportunities arose as a result of dislocations in the financial markets caused by institutional demand.

a. Swap spread trade: ( Case page -4: swap spread example)

Swap spread: the spread between the fixed rate on the swap and the yield on a treasury bond of comparable duration.

Interest rate swaps are contractual agreements in which one party agrees to pay another a fixed rate for a floating rate applied to notional amount. Initially the fixed rate is chosen so that the contract has zero value. An interest rate swap receiving fixed and paying floating has the same cash flow as lending at fixed rate and borrowing at floating rate. This can accomplish by purchasing treasury bonds with floating rate financing. The potential opportunity arises when the swap spread, the spread between the fixed rate on the swap and the yield on a treasury bond of comparable duration is narrow or wide.

In the LTCM case Interest rate swap example, If LTCM hold these until maturity they can get 3 basis point profit on notional amount. But there is a larger profit if the yields widen and no need to hold the position until maturity.

Profit = (U.S treasury yield -repo rate) - (swap fixed rate - labor)

b. Fixed rate residential mortgages: LTCM traded contracts on pools of fixed-rate residential mortgages that were financed by quasi-U.S. government agencies, such as the Federal

National Mortgage Association (FNMA) Federal Home Loan Mortgage Corporation (FHLMC), and Government National Mortgage Association (GNMA). These packaged mortgages were collateralized by houses in U.S. cities and towns, and they were backed by the good faith of these

quasi-government agencies. Interest payments on these packaged mortgages are often separated from the principal, and investors can purchase securities based on the interest-only cash flows or the principal-only cash flows. The interest-only securities pose a problem for investors because homeowners have the inconvenient habit of refinancing their homes when interest rates fall but holding onto their mortgages when rates rise. Therefore, when interest rates fall, the value of these interest only securities falls. LTCM used its expertise in econometric modeling to predict

mortgage repayment rates and movements in the values of these financial instruments as interest rates rose and fell. When the value of an interest-only security was out of whack with LTCM's predictions, the company sprang into action, often using interest-rate swaps to hedge its unwanted interest-rate risks. These default instruments were trading as high as 25 basis points. LTCM could finance these securities at labor -12.5 basis points. Total spread is 37.5. LTCM believed this trading strategy arose because many investors lacked prepayment model.

c. Japanese government bond swap spread: It is similar to US Treasury bond swap spread, the swap spread is the difference between the fixed rate on swap and the yield on a similar-duration Treasury bond. The Japanese swap strategy involved long positions in Japanese government bond and in futures on those bonds, hedged by Libor-yen interest rate swaps. The profit of this type of strategy is , if we assume no outflow (bonds was purchased with 100% financing at repo rate), the cash flow of the strategy is : (Libor-repo) - swap spread. If Libor is greater than repo and a swap spread at its historical low, the net profit is secured; therefore limiting the risk. Usually the net spread is in single basis point. LTCM had at most $10 million per basis point exposure to this trade.

d. Yield curve relative value trade: Yield curve trades are transactions that take advantage of inconsistent dips and spikes in the yield curve. For example forward interest rates for years 4 to 7 might be significantly higher than would seem appropriate, given the rates for year 0 to 3 and for years 8 on ward. LTCM constructed a "butterfly" spread on the yield curve where they thought that bulges and dips in the yield curve where due to investor preferences for specific maturities but not to their expectations. Because convergence did not have to occur, yield curve trades were speculative, but the risk per dollar of exposure was low. LTCM usually Constructed these trades such that its exposure was $3 million per basis point.

e. Volatility trade: LTCM made numerous volatility trades, focusing most of its positions on the

U.S. markets (S&P 500 index) and selected foreign markets, such as France's CAC, Germany's DAX, and FTSE in the United Kingdom. It involved selling long-maturity put and call options on board stock market indexes and dynamically hedging the position so that it had no exposure to the index level itself. LTCM sold puts and calls when the demand and prices for long term options rose. The rise in option prices arose when there was strong demand