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 that leverage, it took on trading positions with an estimated potential value of $1.25 trillion. Despite the fund's seemingly brilliant strategy, the high leverage meant that it did not take much of a setback to wipe out the fund's underlying capital. And the potential freezing of $1 trillion of positions, even temporarily, was seen as a major risk to the system.
a. What is leverage? What information from this excerpt indicates that Long-Term Capital Management was highly leveraged?
b. What risks did Long-Term Capital Management's high leverage pose to the firm? What risks did it pose to the financial system?