LTCMs Impact on the International Financial System
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. 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 th
Central banks and supervisory authorities have recognized the importance of maintaining financial stability in the past few decades. The increased interaction between large institutions has increased the rapid spread of financial problems across institutions and markets. Financial problems, such as sharp reduction of financial resources, may have negative consequences on production, welfare and employment. Since the supervision of registered investment institutions does not protect against investment risks, a large equity base and trading position hedge fund, such as LTCM, may pose a threat to financial stability. In this context, supervisory authorities were worried about the size of trading positions, the potentially high leverage and the lack of disclosure by these institutions. It leads one to ask; was LTCM an isolated incident? Could another firm pose this sort of danger again? In national forums and in an international context, authorities are discussing the improvement of disclosure of financial data by unregulated participants in financial markets. This can be done on a voluntary basis with initiatives towards self-regulation of groups of institutions or by internationally coordinating regulations. Supervisory authorities support this idea, but doubt whether increased disclosure is enough to fix the potential problems large hedge funds, such as LTCM, can create.18 (The New York Times Magazine, New York, January 24, 1999) p. 42 It is impossible to determine for certain what specific factors caused LTCM's collapse and near-demise. Many say that the excessive amount of leverage the fund was using (about 30 times their capital) magnified their losses inordinately when they began losing cash.10 Also, LTCM relied on an academic pricing model that ultimately proved to be a model only applicable during "normal" market conditions, and not in extreme conditions. Magnified risk and theoretical economics certainly played a role in LTCM's near demise. Using arbitrage techniques that appeared infallible, LTCM used excessive leverage to magnify its earnings. Contrary to the myth, hedge funds are not all highly leveraged. LTCM was often leveraged at about thirty times its capital and the institution was primarily borrowing from the same companies that had invested in it. Many companies invested in LTCM under the assumption that LTCM's strategies were infallible.3 19. "The LTCM crisis and its Consequences for Banks and Banking Supervision" Another contributor was the global financial crisis in September 1998. There were two likely "smoking guns" of that particular global financial anomaly. The first was the currency reform in Thailand and the ensuing devaluation of the nation's currency. The second was the Russian government defaulting on their debts, which dried up the liquidity associated with the ruble and Russian financial assets.
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Approximate Word count = 3983
Approximate Pages = 16 (250 words per page double spaced)
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