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
