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In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to tướng buy things, estimating that future profits will be many times more than thở the cost of borrowing. This technique is named after a lever in physics, which amplifies a small input force into a greater output force, because successful leverage amplifies the smaller amounts of money needed for borrowing into large amounts of profit. However, the technique also involves the high risk of not being able to tướng pay back a large loan. Normally, a lender will mix a limit on how much risk it is prepared to tướng take and will mix a limit on how much leverage it will permit, and would require the acquired asset to tướng be provided as collateral security for the loan.
Leveraging enables gains to tướng be multiplied. 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.
Leverage can arise in a number of situations, such as:
- securities lượt thích options and futures are effectively bets between parties where the principal is implicitly borrowed/lent at interest rates of very short treasury bills.
- 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, sánh any profits or losses are shared among a smaller base and are proportionately larger as a result.
- businesses leverage their operations by using fixed cost inputs when revenues are expected to tướng be variable. An increase in revenue will result in a larger increase in operating profit.
- hedge funds may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.
While leverage magnifies profits when the returns from the asset more than thở offset the costs of borrowing, leverage may also magnify losses. A corporation that borrows too much money might face bankruptcy or mặc định 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%.; also in this case the involved subject might be unable to tướng 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 tướng renew mortgages when the value of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to tướng 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 tướng the revised equity value, multiplying losses as prices continue to tướng go down. This can lead to tướng rapid ruin, for even if the underlying asset value decline is mild or temporary 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 which may rapidly be converted to tướng cash.
There is an implicit assumption in that trương mục, however, which is that the underlying leveraged asset is the same as the unleveraged one. If a company borrows money to tướng modernize, add to tướng its product line or expand internationally, the extra trading profit from the additional diversification might more than thở offset the additional risk from leverage. Or if an investor uses a fraction of his or her portfolio to tướng 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. 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 tướng a given asset always adds risk, it is not the case that a levered company or investment is always riskier than thở an unlevered one. In fact, many highly levered hedge funds have less return volatility than thở unlevered bond funds, and normally heavily indebted low-risk public utilities are usually less risky stocks than thở unlevered high-risk technology companies.
A good khuyến mãi 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.
Accounting leverage is total assets divided by the total assets minus total liabilities. Notional leverage is total notional amount of assets plus total notional amount of liabilities divided by equity. 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:
- 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 tướng 1. The notional amount is $100 ($100 of oil), there are no liabilities, and there is $100 of equity, sánh notional leverage is 1 to tướng 1. The volatility of the equity is equal to tướng the volatility of oil, since oil is the only asset and you own the same amount as your equity, sánh economic leverage is 1 to tướng 1.
- Borrow $100 and buy $200 of crude oil. Assets are $200, liabilities are $100 sánh accounting leverage is 2 to tướng 1. The notional amount is $200 and equity is $100, sánh notional leverage is 2 to tướng 1. The volatility of the position is twice the volatility of an unlevered position in the same assets, sánh economic leverage is 2 to tướng 1.
- Buy $100 of a 10-year fixed-rate treasury bond, and enter into a fixed-for-floating 10-year interest rate swap to tướng convert the payments to tướng floating rate. The derivative is off-balance sheet, sánh it is ignored for accounting leverage. Accounting leverage is therefore 1 to tướng 1. The notional amount of the swap does count for notional leverage, sánh notional leverage is 2 to tướng 1. The swap removes most of the economic risk of the treasury bond, sánh economic leverage is near zero.
- EBIT means Earnings before interest and taxes.
- DOL is Degree of Operating Leverage
- DFL is Degree of Financial Leverage
- DCL is Degree of Combined Leverage
- ROE is Return on equity
- ROA is Return on assets
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Accounting leverage has the same definition as in investments. There are several ways to tướng define operating leverage, the most common. is:
Financial leverage is usually defined as:
For outsiders, it is hard to tướng calculate operating leverage as fixed and variable costs are usually not disclosed. In an attempt to tướng estimate operating leverage, one can use the percentage change in operating income for a one-percent change in revenue. The product of the two is called Total leverage, and estimates the percentage change in net income for a one-percent change in revenue.
There are several variants of each of these definitions, and the financial statements are usually adjusted before the values are computed. Moreover, there are industry-specific conventions that differ somewhat from the treatment above.
Before the 1980s, quantitative limits on ngân hàng leverage were rare. Banks in most countries had a reserve requirement, a fraction of deposits that was required to tướng be held in liquid size, 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 tướng be funded in the size 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 ngân hàng was supposed to tướng be "adequately capitalized," but these were not objective rules.
National regulators began imposing formal capital requirements in the 1980s, and by 1988 most large multinational banks were held to tướng 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 ngân hàng is required to tướng hold 8% capital against an asset, that is the same as an accounting leverage limit of 1/.08 or 12.5 to tướng 1.
While Basel I is generally credited with improving ngân hàng 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 tướng pick the riskiest assets in each bucket (for example, the capital requirement was the same for all corporate loans, whether to tướng solid companies or ones near bankruptcy, and the requirement for government loans was zero).
Work on Basel II began in the early 1990s and it was implemented in stages beginning in 2005. Basel II attempted to tướng limit economic leverage rather than thở accounting leverage. It required advanced banks to tướng estimate the risk of their positions and allocate capital accordingly. While this is much more rational in theory, it is more subject to tướng estimation error, both honest and opportunitistic. The poor performance of many banks during the financial crisis of 2007–2009 led to tướng calls to tướng 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 tướng, not instead of, Basel II economic leverage limits.
Financial crisis of 2007–2008
The financial crisis of 2007–2008, lượt thích 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 tướng their wages, and relative to tướng the value of collateral assets. When trang chính 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). Bankruptcy examiner Anton R. Valukas determined that the true accounting leverage was higher: it had been understated due to tướng dubious accounting treatments including the so-called repo 105 (allowed by Ernst & Young).
- Banks' notional leverage was more than thở twice as high, due to tướng off-balance sheet transactions. At the over of 2007, Lehman had $738 billion of notional derivatives in addition to tướng the assets above, plus significant off-balance sheet exposures to tướng special purpose entities, structured investment vehicles and conduits, plus various lending commitments, contractual payments and contingent obligations.
- 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. This is not a standardized computation, but it probably corresponds more closely to tướng what most people think of when they hear of a leverage ratio.
Use of language
Levering has come to tướng 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 tướng its use as a verb, as well. It was first adopted for use as a verb in American English in 1957.
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- Coupon leverage
- Homemade leverage
- Leveraged buyout
- Margin (finance)
- Operating leverage
- Repurchase agreement
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