What is Leverage?

What is leverage?

In its simplest form, financial leverage is the use of borrowed money to make investments. That potentially sounds like a counter-intuitive proposition but if you think about it, ordinary companies of all sizes borrow money from their banks every day to invest in productive assets which might take the form of plant, stock or premises. But leverage, when it is used in financial markets, has the potential to super-charge returns on financial assets.

Put simply: if the asset you are buying as a leveraged investor goes up in value, then your use of financial leverage will amplify the returns you make on your investment. Conversely, if you borrow money to make an investment that subsequently goes down in value, then your losses are amplified by your use of leverage.

Explain the amplification effect of using leverage in an example

Maybe your first home costs £500,000. You’ve saved for a deposit of £100,000 and, because you have a strong credit score and have built up a meaningful deposit, your bank will lend you the other £400,000 to finance the rest of the purchase.

So your initial deposit of £100,000 has financed a house purchase of £500,000. Let’s roll forward 12 months and, luckily for you, the housing market is booming which means the value of your house has risen by 10% over the year so that it is now worth £550,000.

What does this mean? Well you now own a house that is worth £550,000 but you still owe the bank £400,000. And because the value of your house is now £550,000, the new value of your “equity”, the deposit you provided, which was £100,000 has now grown to £150,000. In just one year you have managed to achieve a return of 50% on the initial investment that was your deposit. It has risen from £100,000 to £150,000.

What is spread betting?

Spread betting is built entirely on the notion of leverage. Spread betters only have to deposit, say, 20% of the value of a trade to fund it – this 20% deposit is known as the margin. By definition, this is a leveraged trade because a £20 margin allows you to fund a £100 trade. Non-leveraged investors wanting to make the same investment outright from day one, by contrast, have to put up £100 to take the same amount of investment risk.

Spread betting works in the same way as leverage, in which it can enhance or alternatively demolish your investment returns. Spread betters are exposed to market volatility. If their bet is on a security, commodity or index rising and it instead falls in value, they are required to post additional margin to keep the trade afloat. Same thing if the better is betting on a security falling: if it rises in value, they will be required to post additional margin.

Contracts for Difference (or CFDs) are another product, very similar to spread betting, which are widely-used by individual investors to make leveraged investments where only a small change in the value of an underlying security can amplify gains or losses under the CFD itself. So if you want to make a levered investment there is no need to go to the bank to borrow money, there are financial trading intermediaries who will synthesise it for you in the form of a CFD.

How is leverage used by financial institutions?

Hedge funds, private equity firms, investment banks and a whole host of institutional investors use leverage as a basic building block of their businesses. One of the most spectacular and storied examples of leveraged trading going disastrously wrong is the infamous debacle of hedge fund Long-Term Capital Management in 1998.

LTCM had an equity stack of around 5 billion dollars, but the firm’s balance sheet stood at around 125 billion dollars, mainly consisting of borrowed money. That gave it leverage of 25x. The firm also maintained vast leveraged derivatives positions with a notional principal estimated at 1.25 trillion dollars.

When Russia defaulted on its debt, markets around the world went into a tailspin and LTCM’s leverage and losses rose exponentially. Such was the magnitude of the firm’s trades that risk of failure at the time imperilled the global financial system. In the end, the Federal Reserve Bank of New York masterminded a hastily-arranged 3.65 billion dollar loan funded by 15 of the world’s biggest banks.

Finally we can’t omit the most levered financial sector of all, which is the banking sector. Leverage is fundamental to, and sits at the centre of, all banks’ business models. If leverage is the act of borrowing money to make investments in financial assets, then this is what all banks do every day. They take deposits from their customers, and lend that money to other customers, thereby generating financial assets.