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In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving using debt (borrowed funds) rather than fresh equity (value of owned assets minus liabilities) 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 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.

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[edit]

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

  • securities like options and futures are effectively bets between parties where the principal is implicitly borrowed/lent at interest rates of very short treasury bills.[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 profit.[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.

Risk[edit]

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] also in this case the involved subject might be unable to refund the incurred significant total loss.

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.

There is an implicit assumption in that account, however, which is that the underlying leveraged asset is the same as the unleveraged 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 or her portfolio to margin stock index futures (high risk) and puts the rest in a low-risk money-market fund, he or she 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 heavily indebted low-risk public utilities are usually less risky stocks than unlevered high-risk technology companies.[6]

Measuring[edit]

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.[8]

Investments[edit]

Accounting leverage is total assets divided by the total assets minus total liabilities.[9] 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]

  • Buy $100 of crude oil with money out of pocket. Assets are $100 ($100 of oil), there are no liabilities, and assets minus liabilities equals owners' equity. Accounting leverage is 1 to 1. The notional amount is $100 ($100 of oil), there are no liabilities, and there is $100 of equity, so notional leverage is 1 to 1. The volatility of the equity is equal to the volatility of oil, since oil is the only asset and you own the same amount as your equity, so economic leverage is 1 to 1.
  • Borrow $100 and buy $200 of crude oil. Assets are $200, liabilities are $100 so accounting leverage is 2 to 1. The notional amount is $200 and equity is $100, so notional leverage is 2 to 1. The volatility of the position is twice the volatility of an unlevered position in the same assets, so economic leverage is 2 to 1.
  • Buy $100 of a 10-year fixed-rate treasury bond, and enter into a fixed-for-floating 10-year interest rate swap to convert the payments to floating rate. The derivative is off-balance sheet, so it is ignored for accounting leverage. Accounting leverage is therefore 1 to 1. The notional amount of the swap does count for notional leverage, so notional leverage is 2 to 1. The swap removes most of the economic risk of the treasury bond, so economic leverage is near zero.

Abbreviations[edit]

Corporate finance[edit]

Accounting leverage has the same definition as in investments.[10] There are several ways to define operating leverage, the most common.[11] is:

Financial leverage is usually defined[9][12] 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.[13] The product of the two is called Total leverage,[14] and estimates the percentage change in net income for a one-percent change in revenue.[15]

There are several variants of each of these definitions,[16] and the financial statements are usually adjusted before the values are computed.[9] Moreover, there are industry-specific conventions that differ somewhat from the treatment above.[17]

Bank regulation[edit]

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.[18]

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.[19]

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).[18]

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.[19] 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.[20]

Financial crisis of 2007–2008[edit]

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

  • Consumers in the United States and many other developed countries had high levels of debt relative to their wages, and relative to the value of collateral assets. When home prices fell, and debt interest rates reset higher, and business laid off employees, borrowers could no longer afford debt payments, and lenders could not recover their principal by selling collateral.
  • Financial institutions were highly levered. Lehman Brothers, for example, in its last annual financial statements, showed accounting leverage of 31.4 times ($691 billion in assets divided by $22 billion in stockholders’ equity).[21] Bankruptcy examiner Anton R. Valukas determined that the true accounting leverage was higher: it had been understated due to dubious accounting treatments including the so-called repo 105 (allowed by Ernst & Young).[22]
  • Banks' notional leverage was more than twice as high, due to off-balance sheet transactions. At the end of 2007, Lehman had $738 billion of notional derivatives in addition to the assets above, plus significant off-balance sheet exposures to special purpose entities, structured investment vehicles and conduits, plus various lending commitments, contractual payments and contingent obligations.[21]
  • On the other hand, almost half of Lehman's balance sheet consisted of closely offsetting positions and very-low-risk assets, such as regulatory deposits. The company emphasized "net leverage", which excluded these assets. On that basis, Lehman held $373 billion of "net assets" and a "net leverage ratio" of 16.1.[21] This is not a standardized computation, but it probably corresponds more closely to what most people think of when they hear of a leverage ratio.[citation needed]

Investor protection[edit]

In recent years, financial regulators in developed markets have introduced measures to limit the amount of leverage that retail investors can take on, particularly across foreign exchange transactions. These restrictions sought to limit speculation and protect retail investors against unexpected losses.

USA[edit]

In the United States, the Commodity Futures Trading Commission (CFTC) limits leverage available to retail forex traders to 50:1 on major currency pairs and 20:1 for all others[23].

Major currencies include the Australian dollar, the British pound, the Canadian dollar, the Danish Krone, the euro, the Japanese yen, the New Zealand dollar, the Norwegian Krone, the Swedish Krona, the Swiss franc and the US dollar. The National Futures Association (NFA) is authorized to periodically review the list of major currencies, in light of changes in volatility[23].

The initial version of the CFTC's 2010 regulations proposed lowering leverage limits to 10:1[23]. But the CFTC adopted the higher 50:1 and 20:1 leverage limits described following criticism from Forex market participants. No such restrictions existed prior to 2010, when these rules came into effect.

Japan[edit]

In Japan, the Financial Services Agency (FSA) restricted leverage available to retail traders across foreign exchange transactions as early as 2010. Maximum leverage was capped at 50:1 in August 2010, and was subsequently reduced to 25:1 in August 2011[24].

EU[edit]

In Europe, the European Securities and Markets Agency (ESMA) caps the amount of leverage that brokers and CFD providers can offer retail investors. These limits, which came into effect in 2018, vary between 30:1 and just 2:1, depending on the asset class[25]. More volatile asset classes, like crypto-currencies, tend to attract lower limits.

ESMA’s limits on leverage are:

  • 30:1 for major currency pairs;
  • 20:1 for non-major currency pairs, gold and major equity indices;
  • 10:1 for commodities other than gold and non-major equity indices;
  • 5:1 for individual equities and other reference values;
  • 2:1 for crypto-currencies.

ESMA’s major currency pairs comprise any two of the following currencies: the US dollar, the euro, the Japanese yen, the pound sterling, the Canadian dollar or the Swiss franc[26]. All other currencies are deemed non-major.

ESMA’s major indices are any of the following equity indices: FTSE 100, CAC 40, DAX30, DJIA, S&P 500, NASDAQ, NASDAQ 100, Nikkei 225, ASX 200, EURO STOXX 50[26]. All other indices are deemed non-major.

UK[edit]

The UK’s Financial Conduct Authority (FCA) onshored ESMA’s restrictions on leverage in 2019[27]. This means that ESMA’s measures outlined above became part of UK domestic law when the UK left the EU. These measures remain in place to this day.

Rest of the world[edit]

However, some regulators in other parts of the world have adopted significantly looser restrictions on leverage. To this day, some CFD brokers and providers offer leverage between 500 and 1,000 times an investor’s initial deposit, through entities regulated in the Marshall Islands, Saint Vincent and the Grenadines, the Cayman Islands[28].

This has created the potential for regulatory arbitrage, as some CFD brokers allow their customers to choose the entity with which they wish to open a trading account. In fact, it was the influx of European traders into Australian-licensed brokers, following ESMA’s restrictions, which prompted Australia’s financial regulator to introduce its own restrictions on the sale of CFDs to retail clients[29].

Use of language[edit]

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[30]) refer to its use as a verb, as well.[31] It was first adopted for use as a verb in American English in 1957.[32]

See also[edit]

References[edit]

  1. ^ a b Brigham, Eugene F., Fundamentals of Financial Management (1995).
  2. ^ Mock, E. J., R. E. Schultz, R. G. Schultz, and D. H. Shuckett, Basic Financial Management (1968).
  3. ^ Grunewald, Adolph E. and Erwin E. Nemmers, Basic Managerial Finance (1970).
  4. ^ Ghosh, Dilip K. and Robert G. Sherman (June 1993). "Leverage, Resource Allocation and Growth". Journal of Business Finance & Accounting. pp. 575–582.{{cite news}}: CS1 maint: uses authors parameter (link)
  5. ^ Lang, Larry, Eli Ofek, and Rene M. Stulz (January 1996). "Leverage, Investment, and Firm Growth". Journal of Financial Economics. pp. 3–29.{{cite news}}: CS1 maint: uses authors parameter (link)
  6. ^ a b c d e Bodie, Zvi, Alex Kane and Alan J. Marcus, Investments, McGraw-Hill/Irwin (June 18, 2008)
  7. ^ a b c Chew, Lillian (July 1996). Managing Derivative Risks: The Use and Abuse of Leverage. John Wiley & Sons.
  8. ^ Van Horne (1971). Financial Management and Policy.
  9. ^ a b c Weston, J. Fred and Eugene F. Brigham, Managerial Finance (1969).
  10. ^ Weston, J. Fred and Eugene F. Brigham, Managerial Finance (2010).
  11. ^ Brigham, Eugene F., Fundamentals of Financial Management (1995)
  12. ^ "Financial Leverage". Retrieved 16 December 2012.
  13. ^ Damodaran (2011), Applied Corporate Finance, 3rd ed., pp. 132–133>
  14. ^ Li, Rong-Jen and Glenn V. Henderson, Jr., "Combined Leverage and Stock Risk," Quarterly Journal of Business & Finance (Winter 1991), pp. 18–39.
  15. ^ 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.
  16. ^ 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.
  17. ^ 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.
  18. ^ a b Ong, Michael K., The Basel Handbook: A Guide for Financial Practitioners, Risk Books (December 2003)
  19. ^ a b Saita, Francesco, Value at Risk and Bank Capital Management: Risk Adjusted Performances, Capital Management and Capital Allocation Decision Making, Academic Press (February 3, 2007)
  20. ^ Tarullo, Daniel K., Banking on Basel: The Future of International Financial Regulation, Peterson Institute for International Economics (September 30, 2008)
  21. ^ a b c Lehman Brothers Holdings Inc Annual Report for year ended November 30, 2007
  22. ^ Report of Anton R. Valukas, Examiner, to the United States Bankruptcy Court, Southern District of New York, Chapter 11 Case No. 08-13555 (JMP).
  23. ^ a b c "Final Rule Regarding Retail Foreign Exchange Transactions" (PDF). Commodity Futures Trading Commission.{{cite web}}: CS1 maint: url-status (link)
  24. ^ "Regulations on Leverage for FX Transactions". The Financial Futures Association of Japan.{{cite web}}: CS1 maint: url-status (link)
  25. ^ "European Securities and Markets Authority Decision (EU) 2018/1636 of 23 October 2018". EUR-Lex. 31 October 2018.{{cite web}}: CS1 maint: url-status (link)
  26. ^ a b "ESMA's Product Intervention Measures (FAQ)" (PDF). ESMA. 27 March 2018.{{cite web}}: CS1 maint: url-status (link)
  27. ^ "FCA statement on onshoring ESMA's temporary intervention measures on retail CFD and binary options products". FCA. 22 February 2019.{{cite web}}: CS1 maint: url-status (link)
  28. ^ "High Leverage Forex Brokers". Trusted Brokers. February 2022.{{cite web}}: CS1 maint: url-status (link)
  29. ^ James, Eyers (22 August 2019). "CFD players accused of 'regulatory arbitrage'". Financial Review.{{cite web}}: CS1 maint: url-status (link)
  30. ^ Merrian-Webster's Dictionary of Law. Merriam-Webster. June 2011. ISBN 978-0877797197.
  31. ^ "leverage." Merriam-Webster's Dictionary of Law. Merriam-Webster, Inc. 7 June 2011. Dictionary.com
  32. ^ "leverage." Online Etymology Dictionary. Douglas Harper, Historian. 7 June 2011. Dictionary.com

Further reading[edit]

  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.

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