Explain the endogenous (i.e., hedge-fund-related) factors that caused LTCM's portfolio to lose the normal protections afforded by diversification

Question

What will be an ideal response?

Answer 1

The endogenous shocks that hit LTCM can be traced to the chaotic movement of market spreads, which caused one of LTCM's principal measures of risk (i.e., Value at Risk) to underestimate the hedge fund's exposure. These unexpected spread movements were caused, in large part, by the liquidation of hedge fund positions that were created to replicate LTCM's success. As record losses occurred and investor withdrawals increased, these hedge funds sold their similarly structured positions to gain liquidity and reduce their exposures. Their sales caused spreads to move against a broad spectrum of LTCM's positions. Furthermore, in June and July of 1998, Salomon Brothers started to liquidate its proprietary bond arbitrage business, thereby, increasing the supply of securities for sale and eroding LTCM's net asset value.
LTCM was hit hard because its managers underestimated how LTCM's positions were linked to other hedge funds by their similar strategies, and, therefore, the normal protections assured by diversification were not present. Consequently, price volatility, risk tolerances, funding needs, and liquidity requirements were all linked via these fund's similarly structured portfolios. Once competitors learned of LTCM's difficulties, the situation was made worse because they changed their positions in anticipation of LTCM liquidating its portfolio.