Given the economic and political turmoil that took place in 1998, what bet would have earned John Meriwether and his team of arbitrageurs the highest profits?

Question

What will be an ideal response?

Answer 1

Spread trades: The spreads on many of LTCM's trades went haywire. Those that should have narrowed grew wider, and those that should have grown wider narrowed. LTCM could have earned the largest profits by taking positions that were exactly opposite from the ones it took and, therefore, opposite from the positions of hedge funds that imitated LTCM. If we restrict our focus to investments for which spreads were expected to narrow, then LTCM should have bought (instead of sold) the higher-priced securities and sold (instead of bought) the lower-priced securities. Such a strategy would have worked almost across the globe as spreads widened between U.S. Treasury bonds and U.S. mortgage rates, corporate bonds, junk bonds, swaps, and emerging country debt. Especially important were the rising yield spreads between U.S. securities and securities in the Asian Tiger countries (Thailand, the Philippines, Malaysia, South Korea, Indonesia, and Hong Kong), as a result of the collapse of their fixed exchange rate systems. Also, the Russian ruble crisis in August 1998 raised spreads between Russian and U.S. interest rates and caused the ruble to plummet in value.
Outright positions: The bets that would have earned LTCM the highest returns would have been outright positions in fixed income securities. In general, U.S. interest rates fell from January 1998 to May 1998 and then rose thereafter. LTCM could have earned handsome returns by investing in long-term, fixed income securities for the first nine months of 1998 and then reversing these positions in September. In foreign markets, yields rose and currency values fell in the Asian Tiger Countries and Russia. Here, LTCM would have wanted to take short positions in the securities and currencies of the countries under attack.