Appendix 8.1 LTCM s Major Trades Long-Term Capital Management (LTCM) was engaged in numerous types of trades. Even though many of these trades resulted in low-risk spread positions, others were quite speculative. Nevertheless, the underlying rationale for most of its transactions was the same. LTCM s strategy was to search for assets that were relatively mispriced. Once found, it moved quickly to exploit these misalignments. This appendix reviews the two major categories of trades conducted by LTCM, namely spread trades and directional trades. Spread Trades There are two major types of spread trades, those that involve two assets whose prices (or yields) tend to converge with time and those whose prices (or yields) must converge with time. The former type is called a relative-value trade and the later type is called a convergence trade. RELATIVE-VALUE TRADES Relative-value trades are speculative transactions based on belief that spreads will return to their historical averages. In principle, relative-value trades can be transacted between any two assets that have shown a strong historic correlation and whose yield spreads are outside the normal range. For example, LTCM took positions on the spread between U.S. government bonds and U.S. corporate bonds, between triple-a-rated corporate bonds and junk bonds, between U.S. government bonds and emerging market bonds, as well as on the difference between yields on the government debts of different foreign nations (e.g., Argentina, Brazil, China, Korea, Mexico, Poland, Taiwan, Russia, and Venezuela). Relative-value trades tend to have lower risks than outright (naked) positions because asset prices tend to change more than the spread between asset prices, but LTCM amplified these otherwise-diminutive risks by leveraging them with borrowed funds. Paired Trades A popular relative value trade is the paired trade. A paired trade involves an arbitrage between two assets whose prices (yields) usually move in A.8.1.1
A.8.1.2 APPENDIX 8.1: LTCM s Major Trades tandem but occasionally diverge. Often, they involve shares of companies in the same industry, but they can also involve shares of the same company, which are listed simultaneously on two or more exchanges (e.g., London, Tokyo, Zurich, and New York). Due to factors such as differences in liquidity, taxes, expectations, or regulations, these shares do not always trade at equivalent prices. So long as the differential remains the same, there is no way to profit from these discrepancies, but when the spreads widen or narrow, companies (like LTCM) with pockets full of money bet that past spreads will reassert themselves. LTCM placed large bets on paired trades. Swaps LTCM had extensive, worldwide swap positions stretching from the United States to Belgium, Denmark, France, Germany, Great Britain, Hong Kong, Italy, the Netherlands, New Zealand, Spain, Sweden, and Switzerland. Interest-rate swaps are transactions whose notional values (i.e., the face value of the contracts) are never seen on a company s balance sheet. Rather, these iceberg-sized assets and liabilities are recorded off-balance sheet and reported in the footnotes of companies financial statements. All that floats to the surface of the balance sheet is a swap s net value, which is recorded as an asset if the position shows a net profit and a liability if it shows a net loss. The reason for this accounting treatment is because the principal in a swap transaction is never exchanged. No cash is lent or borrowed; so no principal has to be paid back or received in the future. Rather, a swap commits each counterparty to a series of simultaneous cash payments and receipts for the maturity of the contract. Typically, one counterparty pays a fixed rate and receives a floating rate, while the other counterparty does just the opposite. You might be asking what uses such agreements could have. The answer is plenty. Swaps enable companies that start out borrowing at fixed interest rates to transform their payments to floating rates. For companies that expect interest rates to fall and want to benefit from this expectation, such flexibility is important. Similarly, companies that start out borrowing at a fixed rate, perhaps because they were hedging fixed cash inflows, could have their conditions change, thereby making floating rate payments the more prudent choice. Without swaps, these companies would have to borrow at a floating rate and repay the old debt, which could involve paying large underwriting fees and penalties. Swaps can also be used when the capital markets are not perfectly arbitraged to reduce borrowing costs. LTCM took swap positions in anticipation of charging interest rate spreads.
Spread Trades A.8.1.3 Pooled Mortgage Market Investments 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, also known as Fannie Mae), Federal Home Loan Mortgage Corporation (FHLMC, also known as Freddie Mac), and Government National Mortgage Association (GNMA, also known as Ginnie Mae). 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 interestonly 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. Yield Curve Trades Yield curve trades are transactions that take advantage of inconsistent dips and spikes in the yield curve. LTCM bought and sold futures contracts (mainly) to extract these gains based on distortions in the yield/maturity structure of the yield curve. 1 Because convergence did not have to occur, yield curve trades were speculative, but the risk per dollar of exposure was low. CONVERGENCE TRADES Convergence trades involve two assets whose prices must converge with time and, at maturity (if there is a maturity), must be equal. If they do not converge quickly as maturity approaches, riskless profits could be earned by purchasing the cheap one and simultaneously selling the expensive one. LTCM studied the relationships between yields and prices of numerous securities and their respective futures contracts to see if they were out of line. When they were, the company bought the relatively underpriced instrument and sold the relatively overpriced instrument. If the rates converged rapidly and immediately, LTCM would close out these positions prior to maturity, book the profits, and move on to a new deal. But if rates did not converge immediately, LTCM was 1 LTCM often took butterfly positions to exploit yield curve trading opportunities.
A.8.1.4 APPENDIX 8.1: LTCM s Major Trades prepared to finance these positions for extended periods. Earning profits was almost a sure thing, as long as LTCM could wait until the forces of convergence took hold. It was for this reason that LTCM s financing sources (e.g., lines of credit, unsecured debt, and equity base) were so important. An example of a convergence trade that LTCM used to profit from slight price misalignments involved on-the-run and off-the-run U.S. Treasury securities. Price discrepancies in this market occur because on-the-run securities are newly issued and have relatively more active markets than off-the-run securities, which are seasoned. Because of the relatively higher demand, the price of a newly issued Treasury bond with a 30-year maturity might be high compared to an off-the-run bond that was issued six months ago (i.e., with 29.5 years to maturity). LTCM would purchase the relatively low-priced, off-the-run security and simultaneously sell short the high-priced, on-the-run security. After a few days, the on-the-run securities would become seasoned and their prices would converge to the already seasoned securities, thereby earning LTCM a profit. Directional Trades Directional trades were counter to the spirit of LTCM s strategy of arbitraging spreads, and, therefore, they accounted for a minority of the company s positions. These trades involve taking positions based on the direction an investor expects absolute prices or yields to move. For the most part, they are unhedged, or at least involve a lot more risk than spread trades. OUTRIGHT EQUITY PURCHASES On occasion, LTCM purchased equities outright, based on strong hunches about the future price changes of particular shares. In general, such outright acquisitions were the exception rather than the rule because the U.S. margin requirement on share purchases is (and was) 50%, which is head-andshoulders above the margin requirements on derivatives. Because of LTCM s limited equity relative to its assets, the company tried to avoid such positions to conserve capital. RISK ARBITRAGE The term risk arbitrage is a euphemism for speculation in the merger-and-acquisition markets. It is not arbitrage because the risks can be rather large and, therefore, profits are not assured. Normally, LTCM did not have huge risk-arbitrage positions, 2 but it did engage in this type of speculation when there were strong 2 LTCM s risk arbitrage positions in 1997 reached about $6.5 billion. Leah Nathans Spiro, with Jeffrey M. Laderman, How Long-Term Rocked Stocks, Too. It Wasn t Just the Bond Market That LTCM Endangered, Business Week (9 November 1998), 160.
Directional Trades A.8.1.5 reasons. Acquisitions by Westinghouse of CBS and British Telecom of MCI are just two examples of risk-arbitrage transactions in which LTCM took positions. Risk arbitrageurs take positions in companies that are being acquired, and they often take simultaneous positions in the companies that are doing the acquiring. These arbitrageurs make their moves after an acquisition has been announced but before it has been consummated. Usually, an acquirer will make a bid and establish a future date on which payment for shares will be made. Because payment is in the future, there is a difference between the current share price and discounted present value of the offer price for the firm being acquired. This difference could be substantial if the future payment date were quite distant and interest rates were high. In addition to this discount, there is frequently an additional markdown that reflects the market s uncertainty that the deal will actually be carried out. Risk arbitrageurs buy the discounted shares of acquired companies when they feel confident that the merger will go through as planned. Some risk arbitrageurs make a riskier, but potentially more profitable, trade by purchasing the stock of the acquired company and shorting the stock of the acquirer. BUYING AND SELLING VOLATILITY 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. 3 When the markets went haywire during the summer of 1997 and into 1998, LTCM responded to the new opportunities by substantially increasing its volatility trades. To understand the incentives behind volatility trades, remember that an option s price depends on six variables: the spot price of an underlier, expected future volatility of the underlier s returns, expected dividends, risk-free interest rate, strike price of the option, and maturity of the option. Therefore, embedded in every option price is the market s perception about what the volatility in the future will be. To back out the implied volatility from the Black-Scholes formula, all you have to do is enter the five variables other than volatility into the formula and solve for volatility. If the market price of an option had an implied (i.e., embedded) future volatility that was lower than LTCM felt it should be, JM s arb boys would purchase the underpriced option, with the expectation that its price would rise. In general, LTCM analysts believed that markets tend to overreact to bad news; so, there were usually opportunities to profit when turbulence was at its greatest. 3 André F. Perold, Long-Term Capital Management, L.P. (A). Harvard Business School, Product number: 9-200-007 (5 November 1999).