Lesson 3 of 8 · 11 min

Leverage: magnifying gains and losses

Borrowing lets a fund hold a position larger than its own capital, so the leveraged return equals the asset return plus a magnified spread between that return and the borrowing rate.

In short

  • With own capital VcV_c, borrowed funds VbV_b at rate rbr_b and asset return r: rL=r+VbVc(r−rb)r_L = r + \frac{V_b}{V_c}(r - r_b).
  • Leverage helps only when the asset return exceeds the borrowing rate; at r=rbr = r_b the investor is indifferent.
  • Hedge funds borrow through prime brokers (margin financing) or use derivatives.
  • Falling equity in the margin account triggers a margin call; forced selling can lock in or deepen losses.
  • Access to borrowing, on what terms, is an important risk factor in its own right.

Unlock this lesson free for 7 days

Create a free account to get 7 days of full access — every lesson, video, flashcard, mock and the question bank. No card needed.

Start your 7-day free trialLog in
Leverage: magnifying gains and losses · Alternative Investment Performance and Returns