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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

In 1998 Long-Term Capital Management (LTCM) held large convergence trades financed with high leverage. Which statement best explains why the Russian default led to forced liquidation of LTCM's positions?

Spreads widened simultaneously across many markets as investors fled to quality, causing mark-to-market losses and higher margin and haircut demands on a heavily leveraged portfolio. LTCM could not fund these needs or exit its large illiquid positions without moving prices further against itself.

  1. ALTCM's trades were mostly in Russian bonds, which became worthless
  2. BSpreads widened across many markets at once, producing mark-to-market losses and higher haircuts and margin demands on highly leveraged positions that could not be funded or quickly sold without further price impactCorrect
  3. CRegulators ordered LTCM to close all positions after the default
  4. DLTCM's derivatives counterparties were all central clearing houses that demanded full cash settlement

Explanation

LTCM's positions were diversified in theory but correlations rose in the flight to quality. Losses, combined with higher margin and haircuts and illiquid, large positions, created a funding squeeze. The Russian exposure was not the main portfolio, and no regulator forced the closure.

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