2008 Financial Crisis Essay

Introduction:

The 2008 financial crisis really began 10 years earlier, with the collapse of legendary hedge fund, Long Term Capital Management L.P.(LTCM) which was launched in 1994 by John W. Meriwether who earned MBA degree from the University of Chicago and was used to be the head of fixed income arbitrage group at Salomon Brothers in early 1980s. LTCM was established with $1.1 billion in capital (Chincarini, 2012) in Greenwich, Connecticut, making it the largest start-up hedge fund to date. 12 partners of LTCM were all experienced and authoritative Ph.D. or professors with economic, financial and mathematical background from the most prestigious universities in the world including Robert C. Merton, who was a future winner of Nobel Memorial Prize and Myron S. Scholes, who was also a future

There are four major types of risks: market risk, liquidity risk, default risk and short sell risk. Since majority of trades were based on convergence trades, LTCM faces market risk if prices become diverge. Liquidity risk arises when LIBOR increases dramatically and in turn makes financing more expensive. Moreover, when swap spread widens, LTCM’s two-way mark-to-market will force them to add additional cash into one side of the transaction due to margin calls. 20% of LTCM’s portfolio were invested in emerging markets including Brazilian government bonds and Latin American government bonds, debt in these governments are very different from U.S. Treasury bonds. They offer higher yields, but also carry higher risk. When market crashes, they behave more like equity rather fixed income and can crash very quickly. The last on is short sell risk. Short positions in swap spread trades expose LTCM into a risker circumstance since short positions in swap spread trades have negative carries and theoretically, spread could widen