Leverage (finance)

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In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is any technique involving the use of debt (borrowed funds) rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples⁠ ⁠— hence the provenance of the word from the effect of a lever in physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force. Normally, the lender (finance provider) will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan. For example, for a residential property the finance provider may lend up to, say, 80% of the property's market value, for a commercial property it may be 70%, while on shares it may lend up to, say, 60% or none at all on certain volatile shares.

Finance Academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

Debt deferred payment, or series of payments, that is owed in the future

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

Lever simple machine consisting of a beam or rigid rod pivoted at a fixed hinge, or fulcrum

A lever is a simple machine consisting of a beam or rigid rod pivoted at a fixed hinge, or fulcrum. A lever is a rigid body capable of rotating on a point on itself. On the basis of the location of fulcrum, load and effort, the lever is divided into three types. It is one of the six simple machines identified by Renaissance scientists. A lever amplifies an input force to provide a greater output force, which is said to provide leverage. The ratio of the output force to the input force is the mechanical advantage of the lever.

Contents

Leveraging enables gains to be multiplied. [1] On the other hand, losses are also multiplied, and there is a risk that leveraging will result in a loss if financing costs exceed the income from the asset, or the value of the asset falls.

Sources

Leverage can arise in a number of situations, such as:

In finance, margin is collateral that the holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:

Option (finance) Right to buy or sell a certain thing at a later date at an agreed price

In finance, an option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option. The strike price may be set by reference to the spot price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) "exercises" the option. An option that conveys to the owner the right to buy at a specific price is referred to as a call; an option that conveys the right of the owner to sell at a specific price is referred to as a put. Both are commonly traded, but the call option is more frequently discussed.

Futures contract standardized legal agreement to buy or sell something (usually a commodity or financial instrument) at a predetermined price (“forward price”) at a specified time (“delivery date”) in the future

In finance, a futures contract is a standardized forward contract, a legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.

Risk

While leverage magnifies profits when the returns from the asset more than offset the costs of borrowing, leverage may also magnify losses. A corporation that borrows too much money might face bankruptcy or default during a business downturn, while a less-leveraged corporation might survive. An investor who buys a stock on 50% margin will lose 40% if the stock declines 20%. [6]

Bankruptcy legal status of a person or other entity that cannot repay the debts it owes to creditors

Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor.

Risk may depend on the volatility in value of collateral assets. Brokers may demand additional funds when the value of securities held declines. Banks may decline to renew mortgages when the value of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to maintain the ongoing borrowing costs, loans may be called-in.

This may happen exactly at a time when there is little market liquidity, i.e. a paucity of buyers, and sales by others are depressing prices. It means that as market price falls, leverage goes up in relation to the revised equity value, multiplying losses as prices continue to go down. This can lead to rapid ruin, for even if the underlying asset value decline is mild or temporary [6] the debt-financing may be only short-term, and thus due for immediate repayment. The risk can be mitigated by negotiating the terms of leverage, by maintaining unused capacity for additional borrowing, and by leveraging only liquid assets [7] which may rapidly be converted to cash.

On the other hand, the high level of leverage afforded to borrowers involved in forex trading presents relatively low risk per unit due to the relative stability of that market. Compared with other trading markets, forex traders must trade a much higher volume of units in order to make any considerable profit. For example, many brokers offer 100:1 leverage for investors, meaning that someone bringing $1,000 of equity can control a further $100,000 while taking responsibility/ownership for any losses or gains their investments incur. A 1% gain in the value of $101,000 currency purchased will thus generate a profit of $1,010 (ignoring interest), which is a 101% profit on the equity invested. Without the benefit of leverage, the investor would have invested $101,000 of equity and would have gained a profit of only 1%. However, with leverage, if the currency depreciated by 1% the loss would be -101% on the equity invested.

There is an implicit assumption in that account, however, which is that the underlying leveraged asset is the same as the unlevereged one. If a company borrows money to modernize, add to its product line or expand internationally, the extra trading profit from the additional diversification might more than offset the additional risk from leverage. [6] Or if an investor uses a fraction of his portfolio to margin stock index futures (high risk) and puts the rest in a low-risk money-market fund, he might have the same volatility and expected return as an investor in an unlevered low-risk equity-index fund. [7] Or if both long and short positions are held by a pairs-trading stock strategy the matching and off-setting economic leverage may lower overall risk levels.

So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly levered hedge funds have less return volatility than unlevered bond funds, [7] and normally low-risk public utilities with lots of debt are usually less risky stocks than unlevered high-risk technology companies. [6]

Effect on rates of return

Here is an example showing the calculation of the expected return resulting from leverage. There is a short-form calculation and a long-form that is more intuitive. [8] Given:
The following example is for an investor who seeks to purchase shares of a well performing asset (+5% expected growth). The investor seeks to increase the total amount purchased by leveraging the purchase with borrowed money. A lender and the investor establish the following terms: the lender will permit the investor to leverage the purchase by agreeing to a loan that is equal to eight times the equity investment; for every 1 dollar invested (equity), the lender will lend 8 (leverage). The cost of the loan is 4% of the loan amount. +5% asset return
−4% leverage cost
8:1 leverage ratio

LONG-FORM math
The gross total amount of asset performance following the leveraged purchase is equal to the total quantity of asset purchased multiplied by the Asset Return. In this case, the quantity of asset purchased is equal to 9 (8 from loan funds + 1 from equity funds) and the Asset Return is +5%. So the gross total profit from the leveraged asset purchase = 9 times +5% = +45% gross total profit from leveraged asset purchase. To arrive at net profit, the leverage cost is subtracted from the gross total costs. The cost of the loan is 4% of the loan amount, and the loan is 8 per dollar of equity or 8 times −4% = −32% cost. So the sum of total profit and total cost is +45% profit minus 32% cost = 13% net profit from the leveraged purchase per dollar of equity investment = expected leverage return on equity investment.

SHORT-FORM math
Asset Leverage Differential = sum of Asset's Return and the Cost of Leverage Debt = +5%  4% = +1% Rate Leveraged Asset Return
Leveraged Debt to Equity Investment Ratio = 8 divided by 1 = 8 Leverage Factor
Multiply first two lines = Rate of Leveraged Asset Return x Leverage Factor = + 1% × 8 = +8% Return on Leverage
Add Return on Asset's = 5% Equals Rate of Leveraged Asset Return = sum of Asset Return and Leverage 8% + 5% = 13%

Measuring

A good deal of confusion arises in discussions among people who use different definitions of leverage. The term is used differently in investments and corporate finance, and has multiple definitions in each field. [9]

Investments

Accounting leverage is total assets divided by the total assets minus total liabilities. [10] Notional leverage is total notional amount of assets plus total notional amount of liabilities divided by equity. [1] Economic leverage is volatility of equity divided by volatility of an unlevered investment in the same assets. To understand the differences, consider the following positions, all funded with $100 of cash equity: [6]

Abbreviations

Corporate finance

Accounting leverage has the same definition as in investments. [11] There are several ways to define operating leverage, the most common. [12] is:

Financial leverage is usually defined [10] [13] as:

For outsiders, it is hard to calculate operating leverage as fixed and variable costs are usually not disclosed. In an attempt to estimate operating leverage, one can use the percentage change in operating income for a one-percent change in revenue. [14] The product of the two is called Total leverage, [15] and estimates the percentage change in net income for a one-percent change in revenue. [16]

There are several variants of each of these definitions, [17] and the financial statements are usually adjusted before the values are computed. [10] Moreover, there are industry-specific conventions that differ somewhat from the treatment above. [18]

Bank regulation

Before the 1980s, quantitative limits on bank leverage were rare. Banks in most countries had a reserve requirement, a fraction of deposits that was required to be held in liquid form, generally precious metals or government notes or deposits. This does not limit leverage. A capital requirement is a fraction of assets that is required to be funded in the form of equity or equity-like securities. Although these two are often confused, they are in fact opposite. A reserve requirement is a fraction of certain liabilities (from the right hand side of the balance sheet) that must be held as a certain kind of asset (from the left hand side of the balance sheet). A capital requirement is a fraction of assets (from the left hand side of the balance sheet) that must be held as a certain kind of liability or equity (from the right hand side of the balance sheet). Before the 1980s, regulators typically imposed judgmental capital requirements, a bank was supposed to be "adequately capitalized," but these were not objective rules. [19]

National regulators began imposing formal capital requirements in the 1980s, and by 1988 most large multinational banks were held to the Basel I standard. Basel I categorized assets into five risk buckets, and mandated minimum capital requirements for each. This limits accounting leverage. If a bank is required to hold 8% capital against an asset, that is the same as an accounting leverage limit of 1/.08 or 12.5 to 1. [20]

While Basel I is generally credited with improving bank risk management it suffered from two main defects. It did not require capital for all off-balance sheet risks (there was a clumsy provisions for derivatives, but not for certain other off-balance sheet exposures) and it encouraged banks to pick the riskiest assets in each bucket (for example, the capital requirement was the same for all corporate loans, whether to solid companies or ones near bankruptcy, and the requirement for government loans was zero). [19]

Work on Basel II began in the early 1990s and it was implemented in stages beginning in 2005. Basel II attempted to limit economic leverage rather than accounting leverage. It required advanced banks to estimate the risk of their positions and allocate capital accordingly. While this is much more rational in theory, it is more subject to estimation error, both honest and opportunitistic. [20] The poor performance of many banks during the financial crisis of 2007–2009 led to calls to reimpose leverage limits, by which most people meant accounting leverage limits, if they understood the distinction at all. However, in view of the problems with Basel I, it seems likely that some hybrid of accounting and notional leverage will be used, and the leverage limits will be imposed in addition to, not instead of, Basel II economic leverage limits. [21]

Financial crisis of 2007–2008

The financial crisis of 2007–2008, like many previous financial crises, was blamed in part on "excessive leverage".

Use of language

Levering has come to be known as "leveraging", in financial communities; this may have originally been a slang adaptation, since leverage was a noun. However, modern dictionaries (such as Random House Dictionary and Merriam-Webster's Dictionary of Law [24] ) refer to its use as a verb, as well. [25] It was first adopted for use as a verb in American English in 1957. [26]

See also

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References

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  4. Ghosh, Dilip K. and Robert G. Sherman (June 1993). "Leverage, Resource Allocation and Growth". Journal of Business Finance & Accounting . pp. 575–582.CS1 maint: Uses authors parameter (link)
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  7. 1 2 3 Chew, Lillian (July 1996). Managing Derivative Risks: The Use and Abuse of Leverage. John Wiley & Sons.
  8. "Retail Investor .org : How to Use Leverage and Measure Its Effect". www.retailinvestor.org.
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  14. Damodaran (2011), Applied Corporate Finance, 3rd ed., pp. 132–133>
  15. Li, Rong-Jen and Glenn V. Henderson, Jr., "Combined Leverage and Stock Risk," Quarterly Journal of Business & Finance (Winter 1991), pp. 18–39.
  16. Huffman, Stephen P., "The Impact of Degrees of Operating and Financial Leverage on the Systematic Risk of Common Stock: Another Look," Quarterly Journal of Business & Economics (Winter 1989), pp. 83–100.
  17. Dugan, Michael T., Donald Minyard, and Keith A. Shriver, "A Re-examination of the Operating Leverage-Financial Leverage Tradeoff," Quarterly Review of Economics & Finance (Fall 1994), pp. 327–334.
  18. Darrat, Ali F.d and Tarun K. Mukherjee, "Inter-Industry Differences and the Impact of Operating and Financial Leverages on Equity Risk," Review of Financial Economics (Spring 1995), pp. 141–155.
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  20. 1 2 Saita, Francesco, Value at Risk and Bank Capital Management: Risk Adjusted Performances, Capital Management and Capital Allocation Decision Making, Academic Press (February 3, 2007)
  21. Tarullo, Daniel K., Banking on Basel: The Future of International Financial Regulation, Peterson Institute for International Economics (September 30, 2008)
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Further reading

  1. Bartram, Söhnke M.; Brown, Gregory W.; Waller, William (August 2013). "How Important is Financial Risk?". Journal of Financial and Quantitative Analysis. forthcoming. SSRN   2307939 .