Long-Term Capital Management (LTCM) was a US hedge fund founded in 1994 by some of the most celebrated names in quantitative finance, including Myron Scholes and Robert Merton (both later Nobel laureates). By 1998, it had grown to manage tens of billions of dollars with enormous leverage. Its near-collapse in September 1998 remains one of the defining episodes in the history of financial risk management.

The strategy and the risk

LTCM's core approach was convergence arbitrage: identifying small pricing discrepancies between related instruments and taking large positions to profit as the prices converged. In theory, these positions had low risk individually. In practice, to generate meaningful returns on small spreads, LTCM used extreme leverage — borrowing many times its equity capital to scale up position sizes.

The strategy worked well through 1997. But LTCM's positions, though apparently uncorrelated, shared a hidden common factor: they all depended on liquidity continuing to function normally and on historical price relationships holding.

The 1998 crisis

Russia's sovereign default in August 1998 triggered a global flight to quality. Investors rushed out of risky assets and into the safest, most liquid instruments. The price relationships LTCM had bet on — which had always eventually converged — began moving further apart simultaneously across many markets. LTCM was losing money across all its positions at once, in markets it had assumed were uncorrelated.

The leverage that had amplified LTCM's gains now amplified its losses. As losses mounted, LTCM's counterparties demanded more collateral. To meet those calls, LTCM tried to sell positions — but selling into thin, stressed markets moved prices further against it.

The bailout and the lessons

The Federal Reserve Bank of New York organised a private-sector rescue: fourteen major banks contributed capital to prevent LTCM's disorderly collapse, which regulators feared could have cascading effects across global markets. The fund was wound down over the following months.