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

Long-Term Capital Management (LTCM) entered 1998 with very high leverage and large convergence trades. Which description best explains why the August 1998 Russian default led to a liquidity spiral for LTCM?

Spreads widened instead of converging after the Russian default, producing losses and prompting counterparties to raise margin and haircuts. LTCM's positions were so large that selling them would move prices further against it, so funding pressure and market illiquidity reinforced each other in a spiral.

  1. ASpreads widened rather than converged, causing mark-to-market losses and higher haircuts and margin demands, while LTCM's positions were too large to sell without further moving pricesCorrect
  2. BLTCM's positions were all short-dated and matured, leaving it with no assets to pledge
  3. CRegulators froze LTCM's accounts after discovering accounting irregularities in its fund reports
  4. DLTCM's trades were unhedged directional bets on equity indices that collapsed in value

Explanation

LTCM's relative-value trades assumed spread convergence. Flight to quality widened spreads, creating losses; lenders raised haircuts and margin, and LTCM's size meant liquidation would push prices further against it. The trades were hedged convergence trades, not simple directional equity bets.

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