Explanation:
LTCM believed that, although yield differences between risky and riskless fixed-income instruments varied over time, the risk premium (or credit spread) tended to revert (decrease) to average historical levels. This was similar to their equity volatility strategy. Also, their balance sheet leverage was actually in line with other large investment banks (but their true leverage, economic leverage, was not considered).
(Book 1, Module 9.2, LO 9.a)
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Question 61
Which of the following statements regarding the factors leading to the downfall of Long-Term Capital Management (LTCM) is correct?
A
Their trading strategies for fixed income instruments were based on the notion that the credit spreads would ultimately increase.
B
Their trading strategies for equity options were based on the notion that market volatility would ultimately increase.
C
Their balance sheet leverage was far above the levels of other large investment banks.
D
Their models assumed that low-frequency/high-severity events were uncorrelated over time.
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