What is leverage?
• Leverage is another word for debt. Almost everyone in the United States uses leverage. When you take out a mortgage on your home or use your credit card, you are using leverage. You take on debt in order to buy something. Annaly takes out loans to buy mortgage-backed securities. • We use leverage because it can help increase returns. If the asset earns more money than the interest payments on the debt, we can make more than we could if we did not borrow to buy the asset. • In the example used below, let’s say we are given $1 million to invest. We would purchase a portfolio of agency securities and use them as collateral to borrow $10 million (leverage 10x) which we would use to purchase additional securities. In total we would have purchased $11 million of securities paying us a rate of 6.01% and borrowed $10 million at a cost of 5.26%. (The interest rates used in this example are for illustration purposes only. They are not indicative of rates currently available.
Leverage, also referred to as gearing, is a key factor in currency Leverage can accelerate your gains, or losses, even when there are relatively small movements in the currency price. For example when 100:1 leverage is offered and there is £20,000 in your account, you could buy or sell currency pairs up to a value of £2million. While providing the potential for greater returns, leveraging can also lead to greater losses – movements in the value of investments lead to much greater movements in the value of the overall position, which could lead to sudden and large losses.
Suppose a user of a forward market adopts a position worth Rs.100. As mentioned above, no money changes hands at the time the deal is signed. In practice, a good-faith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is ”leverage of 20 times”. This example involves a forward market. More generally, all derivatives involve leverage. Leverage makes derivatives useful; leverage is also the source of a host of disasters, payments crises, and systemic risk on financial markets. Understanding and controlling leverage is equivalent to understanding and controlling derivatives.
