Leverage is most commonly defined 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%.
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.
When not quantified, 'leverage' may also imply relatively higher levels of debt finance.
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.
Example 2: 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 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 3: 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.
- CRD IV
- Leverage Ratio
- Liquidity risk
- Prudential Regulation Authority