Long-Term Capital Management: The Nobel Prize Hedge Fund

On September 23, 1998, executives from fourteen of the world’s largest banks and securities firms agreed to put about $3.6 billion into a single hedge fund. In return they took 90 percent ownership and control. The talks had been hosted by the Federal Reserve Bank of New York, which feared that the fund’s sudden collapse could disrupt markets around the world.⁶⁷

The fund was Long-Term Capital Management. A year earlier, two of its partners, Robert Merton and Myron Scholes, had won the Nobel Prize in economics for their work on pricing options.⁶⁸ The firm’s founder, John Meriwether, was one of Wall Street’s most respected bond traders, and he had assembled a team of exceptionally talented traders and academics.

LTCM’s core strategy was built on small price differences. Many financial assets that are closely related, such as two similar government bonds, usually trade at prices very close to each other. When the gap between them widens beyond its normal range, it has historically tended to narrow again. LTCM would buy the cheaper asset and sell the more expensive one, aiming to profit when the gap closed.

The profit on each trade was tiny. To make it worthwhile, LTCM used leverage on an enormous scale.