Duration and Leverage: Difference between pages

From ACT Wiki
(Difference between pages)
Jump to navigationJump to search
imported>Doug Williamson
(Add link.)
 
(Add link.)
 
Line 1: Line 1:
1.
__TOC__


In finance, duration - strictly defined - is the weighted average timing of all of an instrument’s cashflows, where the weightings are the present values of the cashflows at the current market yield.


By formula, Duration = Sum(PVt)/Sum(PV).
==Financial leverage calculation==


Financial leverage is most commonly quantified as debt divided by Debt plus Equity


Duration is widely used as a risk measure of a portfolio of assets or liabilities.
= D / (D + E).


It gives a general indication of the sensitivity of an instrument's or a portfolio's market price to small changes in market yield. 


(Modified duration measures this in a more refined way.)
<span style="color:#4B0082">'''''Example 1: Leverage calculation'''''</span>


If the amounts of debt and equity were equal then leverage under this definition would be calculated as:


Broadly speaking, the longer the duration, the more sensitive the market price is likely to be to (small) changes in interest rates.
1 / (1 + 1) = 50%.


Duration is also used as a measure to compare debt securities that have different maturities and yields.


==Broader definitions==


More strictly, the duration of an instrument specifies the remaining life of a zero coupon bond with the same value sensitivity (to a very small change in yield).
The term 'leverage' is also used in a broader sense to refer to the amount of debt in a firm's financial structure.


Both can be regarded as equivalent to a single future cash flow after this period of time.  If there is uncertainty about the timing or the occurrence of future cashflows - for example a call option on a bond - then the concept and calculation of duration becomes more complex.
It may also refer to the amount of fixed costs - as opposed to variable costs - in the firm's cost structure.


Used in these broader senses, 'leverage' means very much the same as 'gearing'.


Not to be confused with ''maturity'', which is different.
However, leverage and gearing are normally quantified by different calculations.




2.  
When not quantified, 'leverage' may also imply relatively higher levels of debt finance.


More loosely, the terms ''duration'' and ''Modified duration'' are often used interchangeably. 


Obviously this can lead to potential confusion, so it is important to clarify whether duration or modified duration is intended in any particular context.
==Leveraging up==
 
To 'leverage up' means to increase the level of gearing in an operational or financial structure.  The intention of leveraging up is to improve expected net results.
 
A consequence of leveraging up is normally to increase financial risk.
 
Many financial disasters have been a consequence of leveraging up excessively in this way in earlier periods.
 
The opposite process - reducing financial risk - is known as deleverage.
 
 
==Leverage in banking==
 
Banks tend to have very high levels of leverage, compared with non-financial corporates.
 
Maximum levels of leverage are established by prudential regulation, including regulatory leverage ratios.
 
 
Leverage ratios in banking are usually defined as the ratio of total balance sheet assets to equity.
 
 
==Leverage in derivatives trading==
 
Leverage is also the ratio of the total value of a derivatives contract relative to the size of the required margin or collateral. <br />
 
 
<span style="color:#4B0082">'''''Example 2: Leverage in derivatives trading'''''</span>
 
10:1 leverage means that an investor needs to provide GBP 10,000 in order to control a position of a GBP 100,000 value futures contract while taking responsibility for any losses or gains their investments incur. <br />As a result if the value of the contract rose by 10% to GBP 110,000, there will be a potential profit of 100% (= 10 x 10%) relative to the amount of GBP 10,000 invested.<br /><br />
 
Similarly if the value were to fall by 10% to GBP 90,000, there would be a loss of the all the initial investment.<br />
Again the change in the value of the total position is 10 x the 10% movement in the value of the contract.<br />
In this case, a loss of 10 x 10% = 100%.<br />
<br />
It is also possible to lose more than the entire value of the initial investment.<br />
This is why derivatives trading can be so dangerous for the investor.
 
 
==Making fuller use of existing assets==
 
Leverage can also mean making better or fuller use of an existing asset. 
 
For example, identifying additional assets to use as borrowing collateral.
 
 
<span style="color:#4B0082">'''''Example 3: Virgin's loan notes secured on Heathrow landing slots'''''</span>
 
:"Virgin Atlantic Airways secured an impressive £220m senior secured note transaction using the airline's [rights to use] take-off and landing slots at London Heathrow Airport.
 
:It is the first time in European air travel history that airport slots have been leveraged in this way."
 
:''The Treasurer magazine, February 2017 p25 - Deals of the Year - Bonds below £500m winner.''
 
 
==Leverage as strong negotiating position==
 
In the context of negotiations, leverage refers to the relative negotiating strength of a party.




== See also ==
== See also ==
* [[Convexity]]
* [[Capital structure]]
* [[Effective duration]]
* [[Collateral]]
* [[Fisher-Weil duration]]
* [[CRD IV]]
* [[Life]]
* [[Debt]]
* [[Macaulay duration]]
* [[Deleverage]]
* [[Maturity]]
* [[European Leveraged Finance Association]]
* [[Modified duration]]
* [[Equity]]
* [[Short duration]]
* [[Financial risk]]
* [[Ultra short duration]]
* [[Gearing]]
* [[Leverage Ratio]]
* [[Leveraged]]
* [[Leveraged buyout]]
* [[Leveraged finance]]
* [[Leveraged takeover]]
* [[Liquidity]]
* [[Liquidity risk]]
* [[Note]]
* [[Prudential Regulation Authority]]
* [[Security]]
* [[Stability]]
 
 
==Other resource==
*[http://www.treasurers.org/node/8012 Masterclass: Measuring financial risk, ''Will Spinney'', The Treasurer]


[[Category:Financial_products_and_markets]]
[[Category:Corporate_finance]]

Latest revision as of 16:24, 23 June 2024


Financial leverage calculation

Financial leverage is most commonly quantified as debt divided by Debt plus Equity

= D / (D + E).


Example 1: Leverage calculation

If the amounts of debt and equity were equal then leverage under this definition would be calculated as:

1 / (1 + 1) = 50%.


Broader definitions

The term 'leverage' is also used in a broader sense to refer to the amount of debt in a firm's financial structure.

It may also refer to the amount of fixed costs - as opposed to variable costs - in the firm's cost structure.

Used in these broader senses, 'leverage' means very much the same as 'gearing'.

However, leverage and gearing are normally quantified by different calculations.


When not quantified, 'leverage' may also imply relatively higher levels of debt finance.


Leveraging up

To 'leverage up' means to increase the level of gearing in an operational or financial structure. The intention of leveraging up is to improve expected net results.

A consequence of leveraging up is normally to increase financial risk.

Many financial disasters have been a consequence of leveraging up excessively in this way in earlier periods.

The opposite process - reducing financial risk - is known as deleverage.


Leverage in banking

Banks tend to have very high levels of leverage, compared with non-financial corporates.

Maximum levels of leverage are established by prudential regulation, including regulatory leverage ratios.


Leverage ratios in banking are usually defined as the ratio of total balance sheet assets to equity.


Leverage in derivatives trading

Leverage is also the ratio of the total value of a derivatives contract relative to the size of the required margin or collateral.


Example 2: Leverage in derivatives trading

10:1 leverage means that an investor needs to provide GBP 10,000 in order to control a position of a GBP 100,000 value futures contract while taking responsibility for any losses or gains their investments incur.
As a result if the value of the contract rose by 10% to GBP 110,000, there will be a potential profit of 100% (= 10 x 10%) relative to the amount of GBP 10,000 invested.

Similarly if the value were to fall by 10% to GBP 90,000, there would be a loss of the all the initial investment.
Again the change in the value of the total position is 10 x the 10% movement in the value of the contract.
In this case, a loss of 10 x 10% = 100%.

It is also possible to lose more than the entire value of the initial investment.
This is why derivatives trading can be so dangerous for the investor.


Making fuller use of existing assets

Leverage can also mean making better or fuller use of an existing asset.

For example, identifying additional assets to use as borrowing collateral.


Example 3: Virgin's loan notes secured on Heathrow landing slots

"Virgin Atlantic Airways secured an impressive £220m senior secured note transaction using the airline's [rights to use] take-off and landing slots at London Heathrow Airport.
It is the first time in European air travel history that airport slots have been leveraged in this way."
The Treasurer magazine, February 2017 p25 - Deals of the Year - Bonds below £500m winner.


Leverage as strong negotiating position

In the context of negotiations, leverage refers to the relative negotiating strength of a party.


See also


Other resource

Retrieved from ‘https://wiki.treasurers.org/w/index.php?title=Duration&oldid=55957’