Today is time t. Two zero coupon bonds both have a face value of 100 dollars, which means both bonds are expected to pay $100 at Maturity (time T). Bond A is liquid and is often traded by average institutional investors at zero transaction costs. Bond B is illiquid. Its total direct and indirect trading cost is $5 per trade (either buy or sell). Suppose an average-sized institutional trader who wants to own the two bonds will trade three times in either bond (i.e., first buy it at t, then sell it and buy it back again at some time between t and T). Interest rate for discounting future bond price is zero for both bonds. In other words, everyone in this market is not risk averse. Please answer the following 5 questions.

Question 39

Suppose you are a trader at LTCM. Under what condition, you can make money from trading bond BI. Buy B at t and hold it until T without tradingII. Buy B at t and, between t and T, further trade the bond as frequently as any other average institutional investors but at lower trading costsIII. Short B and buy A

		I, II, III
		I, III
		I, II
		II, III

Question 40

Suppose your fund bought 1 million dollars of Bond B and plan to hold it for 30 years, your fund investors ask you to report your fund performance every year. Since your fund performance is determined by the market price of Bond B, which changes every year due to macro-economic conditions in the market. How to best reduce the influence of the macro-economic conditions on your fund performance year by year?

		Buy 2 million dollars of Bond A
		Short sell 1 million dollars of Bond A
		Buy 1 million dollars of Bond A
		Short sell 2 million dollars of Bond A

Question 41

Suppose bond market liquidity condition has substantially improved after introducing high frequency traders in recent years. The trading costs of Bond B is significantly reduced. Suppose initially LTCM could make 0.4 billion dollars from using a bond trading strategy with a total equity investment of 1 billion dollars, i.e., 40% return on equity. Now after the reduction of transaction costs, they can only make 10% return on equity from trading (i.e., 0.1 billion dollars). In order to bring equity return back to 40%, what they should do?

		Borrow another 2 billion dollars from brokers and use this additional money to trade on the same trading strategy
		Borrow another 1 billion dollars from brokers and use this additional money to trade on the same trading strategy
		Use 0.5 billion dollars in trading Bond A and 0.5 billion dollars in trading Bond B
		Borrow another 3 billion dollars from brokers and use this additional money to trade on the same trading strategy