In referring to the collapse of the Long-Term Capital Management hedge fund in 1998, an article in the New York Times noted that: Starting with just $5 billion in capital, the fund was able to get $125 billion in additional funds. Using the leverage, it took on trading positions with an estimated potential value of $1.25 trillion.
a. What is the leverage?
b. What information from this excerpt indicates that Long-Term Capital Management was highly leveraged?
c. What risks did Long-Term Capital Management's high leverage pose to the firm?
d. What risks did it pose to the financial system?
Cost of debt:
The cost of debt is the amount or the rate that the company is willing to pay on the debt borrowed by the company. This is the interest rate company willing to pay to raise loans from different sources. This is the return of the creditors and debt holders.
Answer and Explanation: 1
a. Leverage is the technique when the companies choose to finance their investments from outside sources rather than using the company's capital. Borrowing the money from creditors, debt holders, and investors are considered a better option by the firms. Under this, there is influence on the people to invest in the company.
b. In this hedge fund, the information when the article indicates about the $5 billion from the capital is being leveraged and that to $125 billion. This statement and analysis show that the long-term capital is leveraged to a great extent. Excessive leverage conditions are also dangerous for the company as it becomes difficult to handle a large amount of debt.
c. The risk that the long-term capital due to the leverage the management has to face is excessive leverage. As this is referred to as both sided sword, which is capable of increasing the profits to a great extent, so is the condition with the losses. Leverage multiplies the losses, which becomes a risky situation for the company as handling and paying off a large amount of debt is a difficult task to manage.
d. The major risk that the financial system faces due to the leverage is the freezing of $1.25 trillion of the positions. This is due to the excessive leverages that have become risky for the company. This statement is raising the risk to the financial system of the company.
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fromChapter 4 / Lesson 12
Leveraged ETFs are short-term trading vehicles that multiply the performance of their underlying index and can move wildly in any given trading session. Learn about leveraged ETFs and a few of the common risks associated with them.