Long-Term Capital Management, 1998

Convergence trades, twenty-five times over

LTCM ran relative value trades — positions that make money as two closely related prices converge — at very high leverage, on the reasoning that each spread was small, well understood and diversified against the others. In August 1998 Russia defaulted, investors everywhere moved into the safest and most liquid assets, and every one of those spreads widened at once. The fund lost around $4.6bn in four months and was recapitalised by fourteen banks convened by the Federal Reserve Bank of New York.

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What the lesson covers

1. What happened
2. The position
3. Why it broke
4. What it cost
5. What it teaches

Key terms

• Convergence trade — Buying the cheaper and selling the dearer of two near-identical instruments, expecting the gap to close.
• On-the-run — The most recently issued and most liquid government bond of a maturity, which trades richer than older issues.
• Flight to quality — A rush into the safest, most liquid assets, which widens every spread that pays for illiquidity at once.
• Leverage ratio — Assets against capital, and so how far a position can move before the capital is gone.
• Funding liquidity — The ability to keep financing a position — the thing that decides whether you can wait for convergence.
• Crowded position — One whose size and holder are known to the market, so an unwind can be anticipated and traded against.

Every key term, A to Z

In practice

Relative value trading is a large and respectable part of the market, and the arithmetic above is why it is run with leverage limits, liquidity horizons and stress scenarios in which every spread widens together. The lesson is quoted in risk committees more often than any other, usually in the form: what happens if we cannot wait?

Read next

• Interest Rate Swap — Trade fixed for floating payments
• Value at Risk — One number for tomorrow’s loss, and what it leaves out
• Asset Swap — Turn a fixed-rate bond into a floating one

In the app, Long-Term Capital Management, 1998 carries a five-step lesson, a worked example and a bank of twelve questions drawn differently every sitting.

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