Alternative Investments: Risk and Return

The hedge fund Long Term Capital Management (LTCM) was founded in 1994 by John Meriwether, a star bond trader who was immortalised in the book 'Liars Poker'. His partners in the fund included two Nobel laureates, Robert Merton and Myron Scholes, both of whom had received the Nobel prize for economics in 1997 for their work developing a new method for determining the value of derivatives.

Unsurprisingly investors were impressed by the fund's credentials and it attracted some US$4.7 billion in investment. However, between 1997 and 1998 a whole series of economic shocks in Asia hit the market, causing volatility which, in turn, sent up the cost of borrowing. While most investors pulled in their horns, LTCM's risk analysis told them that the markets would soon turn. They didn't and on August 17th 1998, the final blow fell when the Russian government was forced to devalue the rouble and imposed a moratorium on its debt payments.

Around the world, the cost of borrowing suddenly jumped and those, like LTCM, who were trading on margin faced margin calls; that is, requests to place even more money on deposit with their brokers to cover their increased exposure. Because of losses sustained already, LTCM was forced to go back to its investors to ask for more money to meet these margin calls. That money was not forthcoming. They tried to sell off some of their positions, but there was no liquidity-nobody wanted to trade.

It was only at this point that the true extent of LTCM's leverage became clear. The US$4.7 billion in investors' capital had been leveraged 27 times to US$129 billion. Making matters worse still, some of the money had been used to buy derivatives, giving the fund notional assets closer to US$1 trillion-roughly the same as the annual budget of the United States. The threat to global financial stability was such that the US Federal Reserve negotiated a rescue package for LTCM involving 15 banks and brokerage firms and around US$3.75 billion in financing for the fund.