Long Term Capital Management L.P (A) Case Solution

1. What would have been the implication for arbitrage strategies such as the one discussed in the case? Consider, for instance, shorting the 10year bond and going long the swap betting that the spread, Δ1(t), would decrease. Imagine implementing it at the beginning of 2008. What would have been the risks of this trade? What would have happened to the annualized net financing/carry costs in basis points in summer and fall 2008?

The case of LTCM is closely related to the downfall of markets in the financial crises of 2008. The arbitrage strategies put LTCM into such a position where the ‘divergence’ in the value of some bonds and equities will cause huge losses to the company, and its equity might experience a drastic decrease. The arbitrage strategies of LTCM were based on the principle of convergence and divergence. The problem with these strategies is that if the market shows even small deviations from the projected path, the concerned party will maintain huge losses.

Moreover, if this scenario is faced in conjunction with moral hazard and information asymmetry than the losses of the company might increase. 

The financial crises started to make its way to the market in fall 2008. Let’s assume that a company implements the same strategy of ‘convergence trade’ at the beginning of 2008. Convergence trade is essentially synthetic and leveraged trades, and they involve short position. The biggest risk with this strategy would have been the realization of temporary or permanent divergence in the value of constituent stocks/bonds.