Let’s Talk Leverage!

BROKER LEVERAGE YOUR CAPITAL (USD) MARGIN BUYING POWERTRADE SIZE1 - 200 $5.00 $1,000.001 - 200 $50.00 $10,000.001 - 200 $500.00 $100,000.001- 500 $20.00 $10,000.001 - 500 $200.00 $100,0

Leverage is any technique involving the use of borrowed funds in the purchase of an asset, with the expectation that the after-tax income from the asset and asset price appreciation will exceed the borrowing cost. Normally, the finance provider would 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 some shares.

Leveraging enables gains and losses to be multiplied.[1] On the other hand, there is a risk that leveraging will result in a loss — i.e., it actually turns out that financing costs exceed the income from the asset, or because the value of the asset has fallen.

 

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

  • individuals leverage their savings when buying a home by financing a portion of the purchase price with mortgage debt.
  • individuals leverage their exposure to financial investments by borrowing from their broker.
  • securities like options and futures contracts are bets between parties where the principal is implicitly borrowed/lent at very short T-bill rates.[2]
  • equity owners of businesses leverage their investment by having the business borrow a portion of its needed financing. The more it borrows, the less equity it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.[3]
  • businesses leverage their operations by using fixed cost inputs when revenues are expected to be variable. An increase in revenue will result in a larger increase in operating income.[4][5]
  • hedge funds may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s