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Answer: LTCM failed to account properly for the illiquidity of its largest positions in its risk calculations.
A major contributing factor to the collapse of LTCM is that it did not account properly for the illiquidity of its largest positions in its risk calculations. LTCM received valuation reports from dealers who only knew a small portion of LTCM's total position in particular securities, therefore understating LTCM's true liquidity risk. When the markets became unsettled due to the Russian debt crisis in August 1998 and a separate firm decided to liquidate large positions which were similar to many at LTCM, the illiquidity of LTCM's positions forced it into a situation where it was reluctant to sell and create an even more dramatic adverse market impact even as its equity was rapidly deteriorating. To avert a full collapse, LTCM's creditors finally stepped in to provide USD 3.65 billion in additional liquidity to allow LTCM to continue holding its positions through the turbulent market conditions in the fall of 1998. However, as a result, investors and managers in LTCM other than the creditors themselves lost almost all their investment in the fund.
Author: LeetQuiz Editorial Team
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A
LTCM had no active risk reporting.
B
LTCM’s stress testing became a risk management department exercise that had little influence on the firm’s strategy.
C
LTCM’s use of high leverage is evidence of poor risk management.
D
LTCM failed to account properly for the illiquidity of its largest positions in its risk calculations.
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