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Leverage is a tool, and like all tools it can be used prudently or not. For example, many investors believe that owning shares in a major commercial bank is a prudent investment. But how do commercial banks generate profits? A typical commercial bank’s mandate can be defined as an “absolute return strategy using a portfolio of debt securities leveraged 10-to-1 or more, where the investment style seeks to realize a consistent spread on the assets in excess of the cost of leverage.”

Leverage There are numerous ways leverage is defined in the investment industry, and there is no consensus on exactly how to measure it. Leverage can be defined as the creation of exposure greater in magnitude than the initial cash amount posted to an investment, where leverage is created through borrowing, investing the proceeds from short sales, or through the use of derivatives. Thus leverage may be broadly defined as any means of increasing expected return or value without increasing out-of-pocket investment.

There are three primary types of leverage:

1. Financial Leverage: This is created through borrowing leverage and/or notional leverage, both of which allow investors to gain cash-equivalent risk exposures greater than those that could be funded only by investing the capital in cash instruments.

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2. Construction Leverage: This is created by combining securities in a portfolio in a certain manner. How one constructs a portfolio will have a significant effect on overall portfolio risk, depending on the amount and type of diversification in the portfolio, and the type of hedging applied (e.g., offsetting some or all of the long positions with short positions).

3. Instrument Leverage: This reflects the intrinsic risk of the specific securities selected, as different instruments have different levels of internal leverage (e.g., $100,000 invested in equity options versus $100,000 invested in government bonds). While the use of leverage is central to the hedge fund industry, hedge funds vary greatly in the degree and nature of their use of leverage. Leverage allows hedge funds to magnify their exposures and thus magnify their risks and returns. However, a hedge fund’s use of leverage must consider margin and collateral requirements at the transaction level, and any credit limits imposed by trading counterparties such as prime brokers. Therefore, hedge funds are often limited in their use of leverage by the willingness of creditors and counterparties to provide the leverage.

Hedge funds’ use of leverage, combined with illiquid positions, whose full value cannot be realized quickly,can make them vulnerable to “liquidity shocks” in the event of significant margin calls. While banks and securities firms often have trading desks with positions similar to those of hedge funds, these institutions have liquidity sources and other income sources that can minimize their vulnerability to liquidity shocks.

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