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

Long-Term Capital Management (LTCM) held positions with an equity base of about USD 4.7 billion and total assets of about USD 125 billion before its 1998 collapse. What was its approximate balance sheet leverage ratio, and which lesson does it best illustrate?

Leverage was about 27 times, from USD 125 billion of assets divided by USD 4.7 billion of equity. LTCM shows that high leverage on convergence trades leaves little buffer, so adverse spread moves and vanishing liquidity can quickly destroy the fund's capital.

  1. AAbout 4.7 times; leverage was modest so losses were due to fraud
  2. BAbout 27 times; high leverage magnified losses and left no buffer when convergence trades moved against it and liquidity dried upCorrect
  3. CAbout 27 times; the fund was fully hedged so losses came only from operational error
  4. DAbout 0.04 times; positions were mostly unlevered cash securities

Explanation

Leverage = 125 / 4.7 = 26.6, about 27 times. With so little equity, small adverse spread moves wiped out capital, and illiquid positions could not be unwound without further price impact. Option 0 inverts the ratio, and there was no fraud or full hedge.

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