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Leverage

So, how did LTCM earn such a high return? After all, making $10 in the Treasury hedge of Figure 12.1 does not seem like a lot of money. A $10 move in a bond priced at $1,000 is only a 1% change. It hardly seems worth the effort. It is like bending over to pick up a nickel on the street. Why bother? Indeed, that is exactly why that nickel is sitting there on the street—everyone else has passed it up. LTCM considered itself to be like a giant vacuum, sucking up all the leftover nickels throughout the world.

But that LTCM was willing to go after those nickels doesn't explain how it created such a high return. The missing key is leverage. Leverage is borrowing money to invest. A common theme on the late-night real estate infomercials is to buy houses with other people's money. Say you buy a $100,000 house by putting up $100 and borrowing $99,900. If the house value increases to $101,000, you have earned a $1,000 profit in equity. The house increased in value only 1%. But you earned $1,000 from a $100 investment. Your return was 1,000%! This is what leverage does for you.


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