Long-Term Capital Management (LTCM) began operations in 1994 with more than $1 billion in capital and what looked like the unbridled potential to succeed. Its founding principals were a virtual whos who of world-class academics and seasoned Wall Street practitioners.

1. Given the economic and political turmoil that took place in 1998, what bet would have earned JK and his team of arbitrageurs the highest profits?

2. Suppose the yield on a two-year Treasury note was 4 percent, and the yield on a five-year Treasury note was 6 percent. If you expected this yield spread to widen, explain the spread trade you would execute.

3. Using the information from Table 7.1, calculate the return on assets and the return on equity if LTCM had earned only a 1 percent net return (instead of a 5 percent net return) on the investment assets purchased with borrowed funds.

4. Why did LTCM have difficulty raising its level of risk?