Question

Research the failure of the so called hedge fund, Long Term Capital Management. An excellent video on LTCM titled “Trillion Dollar Bet” is available from WGBH Boston Video (the video may also be seen from time to time on PBS Television). Was LTCM a hedge fund? Why or why not? What was the problem with their hedging strategy? Does hedging reduce risk to the extent that textbook examples imply? Why or why not?

Answer 1

Long-Term Capital Management (LTCM) was a hedge fund founded in 1994. it generated huge returns in the first few years of operations - 43%, 41%. The problem with their hedging strategy was they took extreme leverage, lacked to diversify the exposures and had inadequate risk models. This put LTCM in a cash flow crisis when an economic shock created intolerable marked to market losses and margin calls. A forced liquidation of its huge positions drove prices down, further compounding their losses.

Hedging helps in reducing risks, but you should be choosing the exposures correctly and with optimal use of leverage. Future and Forwards can lead to huge gains as well as huge losses. They should be used with care and the most important part is to have a robust risk management system in place.