Site icon The Golden Investor

Leverage In Finance : A Two-Edged Sword, How Does It Materialize?

Photo by Tima Miroshnichenko on Pexels.com

In finance, in the broadest sense of the term leverage can refer to several situations : If we talk about corporate finance, it refers to the asset to equity ratio and thus presence of debts on the liabilities side. It also appears in the decomposition of the Return on Equity (ROE) with Return on Assets (ROA):

Where I is the interest rate due on debts. ROA – I is the leverage, it will be positive if the ROA is greater than the cost of debts. Debts create value for the company from an investor’s perspective. The same rationale can be used for funds using leverage. In this case a portfolio manager is borrowing money (has a short cash position / is short buying) to increase his buying power. The portfolio manager in turn pays interests over his short cash position. This means that with the additional amount of money invested it must generates a return greater than the interest paid over this borrowed money.

In these situations the two edged-sword and the danger of leverage are materialized by the increase in overall exposure to the acquired asset. The absolute impact of any movement of the value of the investment is greater in such situations. A more interesting point is reached when we shift our focus over derivatives, products whose values depend on the value of an underlying which can be an asset but also a variable. Examples are: Options, Futures, Swaps, Convertible bonds or CFDs. For these instruments, the leverage materializes less explicitly. The power of these instruments is that they permit investors to expose themselves to greater positions than initial costs.

Options, The Ultimate Leveraged Product For Risk-On Investors

You expect AlphaBeta, a biotech company, to successfully launch its future vaccine in 3 months. Currently, the stock is trading at $25 and the call price is $2 for a strike of $28, e.g. the option is currently out of the money. With $800 you can buy 4 contracts (standardized 100 options/contract). Suppose that at maturity the stock is worth $33 you are in the money. By exercising the profit of this trade is 400 (33 – 28) – 800 = $ 1,200. Representing a 150% return against only a 32% return of the underlying stock. Options allow for leverage without borrowing. Similar operations can be executed with futures and other derivatives. As holder of the options we transfer the risk to the writer of the options by paying a premium. The initial costs are simply the premium paid over the call options of $1, after acquisition the value of the options is increasingly dependent on its intrinsic value, e.g. the difference between strike price and the value of the underlying asset. As the maturity of the options is less than 9 months there is no buying on margin in this scenario.

Figure 1 – Value of call options

The writer of the options at other side of the contracts takes on the risk and receives the premium as compensation for it. However, the writer of the option must meet margin requirements. If the writer of this option, wrote it “naked” (he did not owe AlphaBeta) the margin he should have paid to the broker would have been:

Indeed, the writer receives in any case the premium by writing the options but note that this is not a free lunch, he must afford his protection against the leverage of the product. This protection exceeds the premium received, in addition of the initial margin. Moreover, if things go wrong for the writer he will have to pay the broker if the maintenance margin is broken.

The leverage for this type of product is linked to the convexity of the instruments. For options we pay attention to Gamma, the second derivative of the option price regarding stock price. As stock prices increase, the option comes more in the money and exercising it more profitable. That is the same reason why as stock prices increase, the option price tends to follow the underlying price more closely. The non-linear shape of this dynamic is what creates the leverage effect of this product. This leverage effect makes the short position on options risky, especially when the underlying asset is not very liquid. This has huge consequences for the costs of hedging such short positions and meeting margin requirements. Realize that the option premium is a compensation for being on the sharpest edge of the sword.

Disclaimer: This article has been written for information purposes only from a personal viewpoint. It does not constitute a solicitation, offer, advice, consultancy or investment recommendation and as such is not intended to encourage the purchase of assets. The Golden Investor would like to remind you that any of assets is highly risky and therefore, any investment decision and risk remains with the individual investor.

Bibliography

  1. http://www.vernimmen.com/Vernimmen/Graphs_and_statistics.php
Exit mobile version