Leverage
Leverage calculation
Debt divided by Debt plus Equity = D / (D + E).
Example
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.
Used in this broader sense, 'leverage' means very much the same as 'gearing'.
However, leverage and gearing are normally quantified by different calculations.
Leveraging up
To increase the level of gearing in an operational or financial structure. The intention of leveraging is to improve expected net results.
A consequence of leveraging is normally to increase financial risk.
Many financial disasters have been a consequence of leveraging up excessively in this way in earlier periods.
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
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.
See also
Other links
Masterclass: Measuring financial risk, The Treasurer, July 2012
