Difference between revisions of "Leverage"

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Leverage is the use of various [[financial instrument]]s or [[borrow]]ed [[capital]], such as [[margin]], to increase the potential [[return]] of an [[investment]]. The financial instruments that can be used to create leverage include [[options]] and [[futures]], among others. For example, $1,000 invested in [[stock]]s might buy 10 [[share]]s of XYZ stock, but the same $1,000 can be invested in five options [[contract]]s, thus controlling 500 shares.  
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The use of [[borrow]]ed [[fund]]s along with owned funds for [[investment]] is called leverage. The ratio of borrowed funds to own funds (or debt to equity) is called the [[leverage ratio]].<ref>{{cite web|url=http://www.sjsu.edu/faculty/watkins/leverage.htm|name=Capital Leverage: Financial Intermediation|org=San Jose State University Economics Department|date=December 9, 2008}}</ref> Leverage involves the use of various financial instruments, including [[options]] and [[futures]].
  
Leverage also refers to the amount of [[debt]] used to finance a firm's [[asset]]s. A firm with significantly more debt than [[equity]] is considered to be highly leveraged. Companies use debt to finance their operations. This increases their leverage because it enables them to invest in business operations without increasing equity. For example, if a company formed with an investment of $5 million from investors, the company has $5 million of equity with which to operate. If the company uses [[debt]] [[financing]] by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase [[value]] for [[shareholder]]s.  
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Leverage also refers to the amount of [[debt]] used to finance a firm's [[asset]]s. A firm with significantly more debt than [[equity]] is considered to be highly leveraged. Companies use debt to finance their operations. This increases their leverage because it enables them to invest in business operations without increasing equity.
  
Leverage means greater [[risk]], however. While leverage magnifies gains, it also magnifies losses, so that if an investment moves against the investor, the loss is much greater than if it had not been leveraged.
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[[Portfolios]], however, become [[risk]]ier with leverage. With too much leverage, a market downturn can wipe out all of the [[equity]] and leave the [[investor]] with more [[debt]] than [[asset]]s.<ref>{{cite web|url=http://www.forbes.com/investoreducation/2007/08/20/leverage-debt-margin-pf-education-in_ty_0820investopedia_inl.html|name=Living With Leverage|org=Forbes.com|date=December 9, 2008}}</ref>
 
   
 
   
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== References ==
 
== References ==
 
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[[Category:Definitions]]

Latest revision as of 04:36, 28 July 2016

The use of borrowed funds along with owned funds for investment is called leverage. The ratio of borrowed funds to own funds (or debt to equity) is called the leverage ratio.[1] Leverage involves the use of various financial instruments, including options and futures.

Leverage also refers to the amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. Companies use debt to finance their operations. This increases their leverage because it enables them to invest in business operations without increasing equity.

Portfolios, however, become riskier with leverage. With too much leverage, a market downturn can wipe out all of the equity and leave the investor with more debt than assets.[2]

References

  1. Capital Leverage: Financial Intermediation. San Jose State University Economics Department.
  2. Living With Leverage. Forbes.com.