Hi,
Please explain the different ways the word "leverage"is used in securities trading. I understand it can be used to mean “debt” but also risk and return on one’s investment.
If I said for example that “derivatives are characterized by high leverage” I assume it means high risk of loss or gain. I’m not sure.
I would appreciate different examples of how the word is used in different contexts in trading. I look forward to your feedback.
Thanks
davidmich
The basic meaning of leverage is that it intensifies the effects of market fluctuations on your gains or losses. If you have exposure to, say, a certain share, and you’re in a position where an increase of the share price by x % gives you a gain (if you’re long) or a loss (if you’re short) of more than x %, then you’re leveraged.
There are several different ways to be leveraged. One of them is indeed debt. Suppose you have $1 million. You borrow another $9 million and put all of that money into a given share. The share price increases by 10 %, turning the $10 million into $11 million. You sell, use the proceeds to repay the $9 million that you borrowed (let’s disregard interest here for the sake of simplicity), and have $2 million left. That’s a 100 % win for you on your own money that you put up, so the market fluctuation of 10 % was leveraged into 100 % for you.
Another way to do this would be through derivatives. Suppose there’s a call option that costs you $10 do obtain the right to purchase the share in the future at a price of $50. You put $1 million (of your own money, no borrowing in this example) into 100,000 of these options. The share price goes up 10 %, you win $5 per option, giving you a profit of $500,000. The share price increase of 10 % was leveraged to 50 % for you.
Yet another possibility for you would be to invest in ETFs. There are synthetic (i.e., derivatives-based - the fund managers of the ETF do not invest in the shares themselves but in derivatives on the shares) ETFs where the leverage is built into the ETF shares. You can, for instance, buy shares that track the Dow Jones with a 2x leverage, so that an increase in the Dow Jones by 10 % results in an increase of the value of the ETF shares by 20 %. At least that’s the way it should be - depending on the transactions the fund managers enter, it’s possible that the actual price fluctuation diverges from the thereotical dvelopment, but the aim of the managers is to keep this “tracking error” as small as possible.
There are, in summary, several ways you can achieve leverage if you want to, but the basic meaning is always the same: The amplitude of the fluctuations is multiplied.
I should also add that leverage is not limited to securities trading; it underlies the entire deposit taking and lending business of banks. Suppose a bank has equity (i.e., own money, simplistically speaking) of $100 million, and it has a chance to lend that money to borrowers who pay 5 % on it. That would give the bank a 5 % return on its equity, disregarding administrative costs and the like. But suppose the bank is able to refinance itself by taking deposits in the amount of $900 million, which costs the bank 1 % in interest that it has to pay depositors. It lends the total $1 billion at 5 %, yielding $50 million; then it pays $9 million in interest to be paid to depositors. The remaining $41 million are the bank’s profit (again, disregarding administrative costs), which represent a 41 % return on the $100 million in equity.
Of course, this is a highly simplistic account (pun intended) of the banking business, but I hope it illustrated the point. It also illustrates why banks, eager to maximise profit, have a tendency to increase leverage, whereas much of banking supervision (i.e. the Basel II/IIII rules on own fund requirements) aim at limiting leverage to an extent that represents an acceptable level of risk.
Thanks Schnitte. I just came across these: “Greed” by David Sarna p. 295 …“Late in 2008 all seven of these funds failed to meet their leverage ratios”
and
“PIMCO 's closed -end funds, like dozens of others , had for years issued auction-rate preferreds to borrow money and add leverage to the funds”
and
“deleverage”???
Does “leverage” in the above examples refer to amplifying returns here?
davidmich
The “leverage ratio” is a regulatorily defined upper limit to leverage through debt. It is, essentially, a law that at least a given percentage of your balance sheet must be equity. The own funds requirement in banking supervision do exactly that (it’s more complicated than that, since assets are risk-weighted in banking supervision, so the denominator is not exactly the balance sheet total, but that’s immaterial here), and while I’m not an expert on investment fund supervision I would imagine similar rules apply there. So the first cite simply says that the funds had more debt relative to equity than was required under the leverage ratios.
“Deleveraging” is also a term in the context of leverage through debt. It means, in effect, little more than reducing your debt. You are overly leveraged (i.e., a lot of your assets have been funded through external debt), so you “deleverage” by repaying part of your debt. That implies selling some of your assets to get the money needed to repay.
Thanks again Schnitte. Very helpful .
davidmich