Derivatives Projectfall 2020 Fin 42206220due December 1 2020overvi ✓ Solved

Derivatives Project Fall 2020 - FIN 4220/6220 Due December 1, 2020 Overview The purpose of this project is to allow you to demonstrate critical thinking skills through the analysis of a catastrophe in historical derivatives use. Each project will be completed in groups as assigned. Partial credit may be awarded as appropriate depending on the specific section requirement. Subject Incident Each group will be assigned one of the following events: • Barings Bank • Metallgesellschaft • Amaranth Advisors • Orange County, California • LTCM • The Financial Crisis of 2008 Class Presentation 15% Each group will prepare a 12 minute presentation summarizing your findings from the project. The presenta- tion may be delivered live or from a recording.

Immediately following delivering or playing the presentation for the class, each group will take 5 minutes of questions. Written Report 85% You should prepare a written report that must contain the following sections. Section descriptions contain guidance on what you should include, but is not all inclusive. You may include additional information as appropriate. Each section will be given the weight indicated.

Section word counts are merely suggestions. 1. Organization Background 15% Give a brief history of the subject organization. Include details about the organization’s founding and key events through history. Give background that will help the reader understand why the organization might pursue an investment strategy that required derivatives.

2. Derivatives Use 15% Explain how the organization first started using derivatives. Give general specifics about the kinds of goals the firm had for their derivatives usage. For example, was it to hedge or speculate? you may include example of successful derivatives usage by the organizaiton. 3.

A Failing Strategy 35% Give a detailed description of the derivatives strategy that failed. Explain how the strategy was supposed to work and identify what went wrong. Identify any key players and how their actions affected the outcome. Was there something they could have done to prevent the disaster? 4.

Fallout 25% Explain in detail what happened in the fallout of the catastrophe. Consider if the organization failed, how it was unwound, criminal or civil legal proceedings, regulatory responses, etc. 5. Conclusion 5% Provide a synthesis of what you learned from this research project. Summarize your overall findings.

1 Graduate Student Modification In addition to the above requirements, graduate student groups must produce a simulation/model showing how the derivatives trading system worked. You may use real or simulated historical asset prices, depending on the event you have been assigned. Graduate students’ project sections will be weighted 10%, 75%, and 15% for the presentation, written report, and trading model, respectively. Other Requirements 1. The written report must contain at least 2500 words (10% deduction per 100 words below .

The written report must be turned in as a PDF (5% reduction if any other format is used) 3. The simulation/model (graduate students only) must be in Excel format or another pre-approved format (10% deduction if in an unapproved format) 4. The written report must be well-formatted (5% deduction for poor formatting) 5. The written report must include a title page with key information, including word count. (5% deduction if lacking) 6. All external sources of data and references must be cited in a consistent format (15% deduction for failure to cite) 2

Paper for above instructions

Organization Background

1. Overview of LTCM
Long-Term Capital Management (LTCM) was founded in 1994 by John Meriwether, a former bond trader at Salomon Brothers, along with several renowned economists including Robert Merton and Myron Scholes, who won the Nobel Prize in Economic Sciences. Based in Greenwich, Connecticut, the hedge fund sought to capitalize on the inefficiencies within the global financial markets through advanced quantitative models and leveraging strategies. By 1998, LTCM had amassed over 0 billion in assets, mostly through borrowed funds, demonstrating both the appeal and risks of leveraging for investment (Fischer, 2001).
2. Historical Context
LTCM was established during a period of low volatility and high liquidity in the financial markets, after the end of the Cold War, which contributed to a favorable environment for investing in derivatives. Its founders aimed to exploit arbitrage opportunities between the prices of similar securities – effectively hedging risks by balancing long and short positions. However, it is crucial to understand that the aggressive use of derivatives and leverage were inherent to LTCM's strategy, creating a “perfect storm” scenario when market conditions shifted (Lowenstein, 2000).

Derivatives Use

1. Initial Strategy and Goals
LTCM initially implemented a market-neutral strategy using derivatives to hedge against risks while betting on small price discrepancies. It primarily utilized options, bond derivatives, and various interest rate swaps as tools to execute its strategy. The goals were to achieve high returns with minimal risk, carefully balanced through sophisticated mathematical models that accounted for various market factors (Black, 1999).
2. Successful Trades
One of the more notable successes was LTCM's investments in Russian government bonds. The fund capitalized on perceived mispricing, reaping significant returns. LTCM consistently generated returns for its investors, and by mid-1998, it reported annualized returns of about 40 percent from inception (Metrick & Virazare, 2011). However, reliance on quantitative modeling introduced systemic risks that would ultimately lead to its downfall.

A Failing Strategy

1. Description of the Strategy and the Downfall
The turning point for LTCM’s strategy came during the Russian financial crisis in August 1998. LTCM had heavily invested in Russian debt, expecting an influx of foreign capital to stabilize the Russian economy. However, following Russia’s default on its debt, LTCM's positions became under water, leading to substantial losses. The event highlighted LTCM’s over-reliance on its models that underestimated market volatility and correlations (Harris et al., 2003).
2. Key Players and Failures
Key figures at LTCM, including Meriwether and the Nobel laureates, failed to respond appropriately to emerging risks. Their decision to continue leveraging positions—even during turbulent market signals—reflected a lack of understanding regarding the limitations of their models. Risk management protocols were insufficient, leading to mounting debts of up to .6 billion, equivalent to the entirety of the firm's capital (Mayo, 2014).
3. Preventative Measures and Impacts
Had LTCM implemented more stringent risk management measures, such as stress testing and diversification beyond fixed income, particularly into equities, it might have mitigated some of its vulnerabilities. Critical miscalculations regarding systemic risk represented a primary fault in LTCM’s overall strategy (Krahnen & Wilde, 2006).

Fallout

1. Immediate Consequences
As LTCM faced impending collapse in September 1998, the Federal Reserve Bank convened a meeting with major financial institutions to prevent broader systemic risks within the financial system. The Fed facilitated a