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- The downfall of Long-Term Capital Management (LTCM) was primarily due to excessive risk-taking, limited diversification, and high leverage.
- The rescue intervention for LTCM highlighted the presence of moral hazard and the interconnectedness of financial institutions in the broader financial system.
Deep dives
Formation of LTCM and its Risky Trading Strategies
Long-Term Capital Management (LTCM) was founded in 1994 by brilliant traders and Nobel Prize winners such as Myron Scholes and Robert Merton. The firm's trading strategies focused on spread trades and convergence in the bond market. They believed that capital was too scarce to judge risky bets and provided insurance-like services, narrowing the spreads between different securities. LTCM became highly successful, attracting investments from prestigious institutions and central banks worldwide. However, the firm's trades were highly leveraged, relying heavily on mathematical models and limited diversification. These factors set the stage for significant risks and vulnerabilities in their portfolio.
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