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March 15, 2006
Hedge Funds Focus: Leverage as a Tool
World over hedge funds are known to use specialized investment strategies to be one up on the market and deliver strong returns and minimize risks. Most of you might have wondered what these strategies could be. Well if not all – we at least try to throw some light on one of the tools used by these funds. In this piece we will be highlighting the usage of leverage in the hedge funds strategies to magnify exposures and, as a direct consequence, magnify their risks.
We understand many of our readers might not be familiar with the term ‘leverage’. And for such readers, here is an attempt to explain the term from scratch. The term leverage can be defined in balance-sheet terms – as it refers to the ratio of assets to net worth. There is also an alternatively definition to the term ‘leverage’ – which can be defined in terms of ‘risk’ as well, as it is a measure of economic risk relative to capital.
Hedge funds derive economic leverage in various different ways; some of the common methods are through the use of repurchase agreements, short positions, and derivative contracts. Many a times, even the choice of investment is influenced by the availability of leverage. Much beyond a trading institution’s risk appetite, both balance-sheet and economic leverage can be constrained in some cases by initial margin and collateral at the transaction level, and also by trading and credit limits imposed by trading counterparties.
It might be ok to say that hedge funds are limited in their use of leverage only by the willingness of their creditors and counterparties to provide such leverage. Much like banks and securities firms, although unlike most mutual funds, hedge funds are known to lever their capital bases to increase their total asset holdings by a multiple of the amount of capital invested in the funds.
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