Question

Suppose bond market liquidity condition has substantially improved after introducing high frequency traders in recent years. The trading costs of Bond B is significantly reduced. Suppose initially LTCM could make 0.4 billion dollars from using a bond trading strategy with a total equity investment of 1 billion dollars, i.e., 40% return on equity. Now after the reduction of transaction costs, they can only make 10% return on equity from trading (i.e., 0.1 billion dollars). In order to bring equity return back to 40%, what they should do?

a. Put 0.5 billion dollars in trading Bond A and 0.5 bilion dollars in trading Bond B
b. Borrow another 3 billion dollars from brokers and use this additional money to trade on the same trading strategy.
c. Borrow another 2 billion dollars from brokers and use this additional money to trade on the same trading strategy
d. Borrow another 1 illion dollars from brokers and use this additional money to trade on the same trading strategy

Answer 1

Answer:

b. Borrow another 3 billion dollars from brokers and use this additional money to trade on the same trading strategy.

Explanation:

There is 40% return on the equity investment which means if $1 billion are invested then there can be $0.4 billion profit. LTCM can borrow funds and could earn from investing in equity investment. The return on equity investment is higher than the bonds so it should trade on the same strategy.