LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences. Initially enormously successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis and became a prominent example of the risk potential in the hedge fund industry. The fund was closed in early 2000.

John Meriwether headed Salomon Brothers' bond trading desk until he was forced to resign in 1991 when his top bond trader, Paul Mozer, admitted to falsifying bids on U.S. Treasury auctions. Because Salomon was the largest bidder on treasury bonds at auction, the Treasury department feared that Salomon would be able to take a strategic position on the bonds in order to influence the price.

As such, Salomon (or any single bidder) was restricted from purchasing more than 35% of the bonds sold at any auction. Mozer circumvented this limitation by making fraudulent bids on behalf of Salomon clients and then transferring the bonds to Salomon's accounts following the transaction. The revelation of this scandal depressed the company's share price and drove investor Warren Buffett to sack its chief executive officer, John Gutfreund. Though Meriwether was not directly implicated, calls for his ousting rose within the company and he resigned before he was let go.

In 1993 he announced that he would launch a hedge fund called Long-Term Capital. Meriwether used his well-established reputation to recruit several Salomon bond traders and some brilliant mathematicians.

He also recruited two future Nobel Prize winners, Myron Scholes and Robert C. Merton, both of whom worked in Salomon Brothers' fixed income trading department. Other principals in the firm included Eric Rosenfeld, Greg Hawkins, Larry Hilibrand, William Krasker, Dick Leahy, Victor Haghani, James McEntee, Robert Shustak, and David W. Mullins Jr.

Long-Term Capital consisted of Long-Term Capital Management (LTCM), a company incorporated in Delaware but based in Greenwich, Connecticut. LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch.

Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual funds, as established by the Investment Company Act of 1940—funds which accepted stakes from one hundred or fewer individuals with more than one million dollars in net worth each were exempt from most of the regulations that bound other investment companies. In late 1993, Meriwether approached several "high net-worth individuals" in an effort to secure start-up capital for Long Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments. The bulk of the money, however, came from companies and individuals connected to the financial industry. By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.

The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. Government bonds are a "fixed-term debt obligation", meaning that they will pay a fixed amount at a specified time in the future. Differences in the bonds' present value are minimal, so according to economic theory any difference in price will be eliminated by arbitrage. Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a 30 year treasury bond and a 29 and three quarter year old treasury bond should be minimal—both will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bonds because of a difference in liquidity. By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting the more expensive, but more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond was issued.

As LTCM's capital base grew, they felt pressed to invest that capital and had run out of good bond-arbitrage bets. This led LTCM to undertake more aggressive trading strategies. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998, LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega, which had been in demand by companies seeking to essentially insure equities against future declines.

Because these differences in value were minute—especially for the convergence trades—the fund needed to take highly-leveraged positions to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of about 25 to 1. It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.