Question: Problem: Assume that a hedge fund has $20M equity (from investors), borrows $80M from a prime broker, and invests $100M in assets. The borrowing rate

Problem: Assume that a hedge fund has $20M equity (from investors), borrows $80M from a prime broker, and invests $100M in assets. The borrowing rate is 2%. This is 5:1 leverage defined as A:E (or 4:1 as L:E).

1. What is the return to equity investors (rE) as a function of the return on assets (rA) and the 2% borrowing rate? Evaluate rE for asset returns of -10%, -5%, -3%, 0%, 3%, 5%, 10%.

2. Repeat 1. But now assuming the hedge fund leverage is 10:1 (asset basis).

3. If a prime broker wants collateral coverage on her loan (defined as A:L) to be at least 110%, what asset return would prompt the prime broker to demand a partial loan repayment in the 5:1 and 10:1 cases?

4. Explain how the example in 3. can cause a death spiral for a hedge fund?

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