Leverage

What is Leverage?

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

 

Excel Modeling Course

Everything You Need To Master Excel Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: