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1. Long Term Capital Management [use both the case study and Jorion (2000)].
a. Explain LTCM’s two most important strategies that lead to their largest losses.
LTCM engaged primarily in convergence and relative value strategies. The 2 strategies that lead to their largest losses (3 out of $4.4bn) were interest rate swaps betting on swap spread convergence and selling volatility betting on decreasing volatility to historic levels. The first strategy involved taking a long and an offsetting short position, exchanging floating and fixed rates. This is a convergence trade as there was a specifiable future date by which convergence in the value of the positions should occur. The second strategy was a relative value trade; convergence was expected but not guaranteed except perhaps over a very long horizon. LTCM sold options with a long maturity that corresponded to a strong volatility (20%), while dynamically hedging the position; LTCM would have no exposure to the corresponding equity index. In fact, the S&P 500 has had a much lower volatility in the past (13%) and was expected to come back to historical volatility, which would reduce the relative value of the options sold in the beginning, therefore LTCM would be able to make a profit.
b. Explain the circumstances of the LTCM’s collapse, and why the strategies presented in part a) failed. The strategies mentioned before could only generate tiny profits. Because after all the biases between similar bonds or derivative instruments are small, the profit made from their convergence is also small. Therefore leverage has to be used to create attractive returns. The risk control of LTCM’s was set to the volatility of an unleveraged position in U.S. equities. However, taking into account LTCM’s high leverage level, the risk was beyond people’s expectation back

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