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The LTCM's relative value trading uses market's mispricing: If the yield spread between government bond (low yield) and corporate bond (high yield) is considered to
The LTCM's relative value trading uses market's mispricing: If the yield spread between government bond (low yield) and corporate bond (high yield) is considered to be too wide, then traders can capture an arbitrage opportunity - As the yield spread becomes narrower, the traders can make money. There doesn't seem any flaws in the strategy. What went wrong with LTCM in 1998? There is no mispricing and no arbitrage opportunity in the market in the first place, and LTCM had been just lucky until they collapsed. LTCM borrowed too much money and they invested those money to too risky projects. If it were normal times, the yield spread would have become narrower. However, there was a series of events to make investors demand safe assets more. The government bond yield fell further, so the strategy didn't work within a certain frame. LTCM borrowed for a short period at an adjustable (floating) rate, while they lent the money for a longer period at a fixed rate. As the overall interest rate went up, LTCM's borrowing costs skyrocketed and failed
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