What Is Leverage?

Patrick Curtis

Reviewed by

Patrick Curtis WSO Editorial Board

Expertise: Investment Banking | Private Equity

Leverage is the use of borrowed money to enhance the returns of any investment. Using leverage, an investor is able to achieve the returns of a very large investment whilst only providing the capital for a small investment.

Unfortunately, as well as enhancing returns leverage will also magnify losses. An example of the pros and cons of leverage is below:

  • A hedge fund has $10 million of its own money
  • In year 1, the fund has a good year and returns 10%, or a $1 million profit
  • This is a 10% return on equity ($1,000,000 / $10,000,000)
  • In year 2, the fund borrows $90 million in the money markets and has to pay $5 million per year to service the debt
  • The return in year 2 is 10% again, or $10 million
  • After subtracting the $5 million to service the debt, total profit is $5 million, which is 50%, return on equity ($5,000,000 / $10,000,000)
  • Simply by using borrowed money, the fund has increased its returns from 10% to 50%
  • In year 3 the market turns against the fund, and they experience a loss of 10%
  • This is a loss of $10 million, plus the $5 million to service the debt, which is a total cost of $15 million. This is more than the $10 million of equity in the fund, so it is bankrupt

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Patrick Curtis

Patrick Curtis is a member of WSO Editorial Board which helps ensure the accuracy of content across top articles on Wall Street Oasis. He has experience in investment banking at Rothschild and private equity at Tailwind Capital along with an MBA from the Wharton School of Business. He is also the founder and current CEO of Wall Street Oasis. This content was originally created by member WallStreetOasis.com and has evolved with the help of our mentors.