Explanation of Leverage in Finance
Explanation of Leverage in Finance
What is Leverage?
Leverage is a financial strategy that involves using borrowed money, specifically the use of various financial instruments or borrowed capital, to increase the potential return of an investment. It can also refer to the debt a firm uses to finance assets. When one refers to a company, property, or investment as “highly leveraged,” it means that item has more debt than equity.
Both companies and investors use leverage. Companies can use leverage to finance their assets —instead of issuing more equity to fund operations and acquisitions, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.
How it works
The use of leverage in finance is quite similar to the use of a lever in the real world. Just as a lever can enable you to lift a heavy load with a small force, financial leverage allows you to make a significant investment with a relatively small amount of money. This is achieved by borrowing the rest of the required capital, expecting the profits made from the investment to be greater than the interest on the debt.
In other words, as we defined above, leverage is an investment strategy of using borrowed money or derivatives and index funds to increase the potential return.
How to use it
Leverage can be used in several ways in investing. For example, you can use leverage through options, futures contracts, margin accounts, and ETFs. In real estate, leverage takes the form of mortgages or other loans used to purchase properties. In business, companies can use leverage by using debt to fund operations and expansion projects.
However, the last two are separate from our products; as expected, we use leverage only in the financial markets. For instance, our AP US Large-Cap Hedged Strategy uses an x1.5 leverage.
Non-risk-averse Investors may use leverage to increase their exposure to certain markets or investments. For example, buying shares on margin allows an investor to buy more shares than they could afford with their available funds.
What it can do
When used correctly, leverage can help significantly increase your investments’ returns. It allows you to make larger investments than your personal funds alone. This means that if your investment is successful, you stand to gain much more than if you had only used your own money.
However, it’s important to note that while leverage can amplify profits, it can also amplify losses. If an investment funded with borrowed money goes down, not only could you lose your initial investment, but also the money you borrowed is gone.
Potential earning examples
Let’s say you have $10,000 to invest and expect a 10% return on an investment. Without leverage, your return would be $1,000 ($10,000 x 10%).
However, if you used leverage and borrowed another $10,000 at an interest rate of 5%, your potential return could be higher. You would earn $2,000 ($20,000 x 10%) from the investment and pay $500 ($10,000 x 5%) in interest on the loan. After paying back the loan and interest, your net return would be $1,500 ($2,000 – $500), which is 50% more than what you would have earned without using leverage.
Leverage is a powerful financial tool that allows investors and companies to intensify their potential returns. However, it comes with a higher risk as it can also intensify losses. Therefore, while leverage can be part of a healthy investment strategy when used responsibly and with an understanding of its risks and benefits, it’s not suitable for everyone. Always consider your risk tolerance and investment goals before deciding to use leverage.