»

# definition - Leverage_(finance)

definition of Wikipedia

# Leverage (finance)

In finance, leverage (sometimes referred to as gearing in the United Kingdom, or solvency in Australia) is a general term for any technique to multiply gains and losses.[1] Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.[2] Important examples are:

• A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.[3]
• A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.[4][5]
• Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting$1 million of cash as margin.[6]

## Measuring leverage

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.[7]

### Investments

Accounting leverage is total assets divided by the total assets minus total liabilities.[8] 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.[9] • Buy$100 of crude oil. Assets are $100 ($100 of oil), there are no liabilities. Accounting leverage is 1 to 1. Notional amount is $100 ($100 of oil), there are no liabilities and there is $100 of equity. 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. Notional amount is$200, 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 crude oil, borrow $100 worth of gasoline and sell the gasoline for$100. You now have $100 cash,$100 of crude oil and owe $100 worth of gasoline. Your assets are$200, liabilities are $100 so accounting leverage is 2 to 1. You have$200 notional amount of assets plus $100 notional amount of liabilities, with$100 of equity, so your notional leverage is 3 to 1. The volatility of your position might be half the volatility of an unlevered investment in the same assets, since the price of oil and the price of gasoline are positively correlated, so your economic leverage might be 0.5 to 1.

Another risk of leverage is model risk. Many investors run high levels of notional leverage but low levels of economic leverage (in fact, these are the type of strategies hedge funds are named for, although not all hedge funds pursue them). Economic leverage depends on model assumptions.[6] For example, a fund with $100 might feel comfortable holding$1,000 long positions in crude oil futures and $1,000 of short positions in gasoline futures. The notional leverage is 20 to 1 (accounting leverage is zero) but the fund might estimate economic leverage is only 1 to 1, that is the fund may assume a 10% fall in the price of oil will cause a 9% fall in the price of gasoline, so the fund will lose only 10% net ($100 loss on the oil long and $90 profit on the gasoline short). If that assumption is incorrect, the fund may have much more economic leverage than it thinks. For example, if refinery capacity is shut down by a hurricane, the price of oil may fall (less demand from refineries) while the price of gasoline might rise (less supply from refineries). A 5% fall in the price of oil and a 5% rise in the price of gasoline could wipe out the fund.[9] ### Counterparty risk Leverage may involve a counterparty, either a creditor or a derivative counterparty. It doesn't always do that, for example a company levering by acquiring a fixed asset has no further reliance on a counterparty.[2] In the case of a creditor, most of the risk is usually on the creditor's side, but there can be risks to the borrower, such as demand repayment clauses or rights to seize collateral.[9] If a derivative counterparty fails, unrealized gains on the contract may be jeopardized. These risks can be mitigated by negotiating terms, including mark-to-market collateral.[6] ## Worked Example [19] Calculate equity return given: 5% Projected Return on Investment 4% Cost of Debt 8:1 Leverage Debt:Equity LONG-FORM MATH (I) Profit from investment = Investment * Return on investment = 9 * 5% = 0.45 (II) Interest on debt = Debt * Cost of debt = 8 * 4% = 0.32 (III) Net profit = (I) - (II) = 0.45 - 0.32 = 0.13 Return on Equity = (III) / Equity = 0.13 / 1 = 13% SHORT-FORM GENERIC CALCULATION Return on Debt = Return on Investment - Cost of Debt = 5% - 4% = 1% Net Profit From Debt = Debt * Net Interest Rate = 8 * 1% = 0.08 Net Profit From Equity = Equity * Return on Investment = 1 * 5% = 0.05 Return on Equity = Total Return / Equity = (0.08+0.05) / 1 = 13% ## Leverage and bank regulation Prior to 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 held 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 not objective rules.[20] 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.[21] While Basel I is generally credited with improving bank risk management it suffered from two main defects. It did not require capital for off-balance sheet risks (there was a clumsy provisions for derivatives, but not for 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).[20] 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.[21] 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 the 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.[22] ## Leverage and the financial crisis of 2007–2009 The financial crisis of 2007–2009, like many previous financial crises, was blamed in part on "excessive leverage." However, the word is used in several different senses. • Consumers in the United States and many other developed countries borrowed large amounts of money,$2.6 trillion in the United States alone.[23] For most of this, "leverage" is a euphemism as the borrowing was used to support consumption rather than to lever anything.[24] Only people who borrowed for investment, such as speculative house purchases or buying stocks, were using leverage in the financial sense.
• Financial institutions were highly levered. Lehman Brothers, for example, in its last annual financial statements, showed accounting leverage of 30.7 times ($691 billion in assets divided by$22 billion in stockholders’ equity).[25] 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).[26] Accounting leverage is the ratio usually cited by the press.
• Notional leverage 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.[25] • 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.[25] This is not a standardized computation, but it probably corresponds more closely to what most people think of when they hear a leverage ratio.

## Use of Language

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) refer to its use as a verb as well.[27] It was first adopted for use as a verb in American English in 1957.[28]

## References

1. ^ a b c Brigham, Eugene F., Fundamentals of Financial Management (1995).
2. ^ a b 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, "Leverage, Resource Allocation and Growth," Journal of Business Finance & Accounting (June 1993), p. 575-582.
5. ^ Lang, Larry, Eli Ofek, and Rene M. Stulz, "Leverage, Investment, and Firm Growth," Journal of Financial Economics (January 1996), p. 3-29.
6. Chew, Lillian, Managing Derivative Risks: The Use and Abuse of Leverage, John Wiley & Sons (July 1996).
7. ^ a b c Van Horne, Financial Management and Policy (1971).
8. ^ a b c d Weston, J. Fred and Eugene F. Brigham, Managerial Finance (1969).
9. Bodie, Zvi, Alex Kane and Alan J. Marcus, Investments, McGraw-Hill/Irwin (June 18, 2008)
10. ^ Weston, J. Fred and Eugene F. Brigham, Managerial Finance (2010).
11. ^ Brigham, Eugene F., Fundamentals of Financial Management (1995)
12. ^ Blazenko, George W., "Corporate Leverage and the Distribution of Equity Returns," Journal of Business & Accounting (October 1996), p. 1097-1120).
13. ^ Block, Stanley B. and Geoffrey A. Hirt, Foundations of Financial Management (1997).
14. ^ Li, Rong-Jen and Glenn V. Henderson, Jr., "Combined Leverage and Stock Risk," Quarterly Journal of Business & Finance (Winter 1991), p. 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), p. 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), p. 327-334.
17. ^ Darrat, Ali F. and Tarun K. Mukherjee, "Inter-Industry Differences and the Impact of Operating and Financial Leverages on Equity Risk," Review of Financial Economics (Spring 1995), p. 141-155.
18. ^ Leverage Effect on ROE
19. ^ Math for calculating leverage effects
20. ^ a b Ong, Michael K., The Basel Handbook: A Guide for Financial Practitioners, Risk Books (December 2003)
21. ^ 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)
22. ^ Tarullo, Daniel K., Banking on Basel: The Future of International Financial Regulation, Peterson Institute for International Economics (September 30, 2008)
23. ^ Federal Reserve Statistical Release G19 Consumer Credit.
24. ^ Bureau of Economic Analysis: National Income and Products Account Table 2.1.
25. ^ a b c Lehman Brothers Holdings Inc Annual Report for year ended November 30, 2007.
26. ^ Report of Anton R. Valukas, Examiner, to the United States Bankruptcy Court, Southern District of New York, Chapter 11 Case No. 08-13555 (JMP).
27. ^ ["leverage." Merriam-Webster's Dictionary of Law. Merriam-Webster, Inc. 07 Jun. 2011. <[Dictionary.com http://dictionary.reference.com/browse/leverage>]
28. ^ "leverage." Online Etymology Dictionary. Douglas Harper, Historian. 07 Jun. 2011. [<Dictionary.com http://dictionary.reference.com/browse/leverage>.]

sensagent's content

• definitions
• synonyms
• antonyms
• encyclopedia

Dictionary and translator for handheld

New : sensagent is now available on your handheld

sensagent's office

Shortkey or widget. Free.

Windows Shortkey: . Free.

Vista Widget : . Free.

Webmaster Solution

Alexandria

A windows (pop-into) of information (full-content of Sensagent) triggered by double-clicking any word on your webpage. Give contextual explanation and translation from your sites !

Try here  or   get the code

SensagentBox

With a SensagentBox, visitors to your site can access reliable information on over 5 million pages provided by Sensagent.com. Choose the design that fits your site.

Improve your site content

Add new content to your site from Sensagent by XML.

Crawl products or adds

Get XML access to reach the best products.

Index images and define metadata

Please, email us to describe your idea.

WordGame

The English word games are:
○   Anagrams
○   Wildcard, crossword
○   Lettris
○   Boggle.

Lettris

Lettris is a curious tetris-clone game where all the bricks have the same square shape but different content. Each square carries a letter. To make squares disappear and save space for other squares you have to assemble English words (left, right, up, down) from the falling squares.

boggle

Boggle gives you 3 minutes to find as many words (3 letters or more) as you can in a grid of 16 letters. You can also try the grid of 16 letters. Letters must be adjacent and longer words score better. See if you can get into the grid Hall of Fame !

English dictionary
Main references

Most English definitions are provided by WordNet .
English thesaurus is mainly derived from The Integral Dictionary (TID).
English Encyclopedia is licensed by Wikipedia (GNU).

The wordgames anagrams, crossword, Lettris and Boggle are provided by Memodata.
The web service Alexandria is granted from Memodata for the Ebay search.
The SensagentBox are offered by sensAgent.

Translation

Change the target language to find translations.
Tips: browse the semantic fields (see From ideas to words) in two languages to learn more.

last searches on the dictionary :

6175 online visitors

computed in 0.031s