In the simplest possible way to explain, the leverage is a tool (technique) in the world of finance that allows a person to multiply their gains. The most common way to use it is to buy a high amount of an asset with borrowed funds. The income from the asset or its price increase should in theory cover the amount of borrowed money.
Leverage is a double-edged sword. Any tool or technique that increases the gains carries a high level of risk. Leverage can destroy a trader or investor when the expected income fails to cover the borrowed money. Many forms of the leverage exist, and each and every one of them carries a risk that equals the possible gain. If the potential benefit is tripled by the leverage, then the losses on that investment are also tripled.
Some good example of the leverage use in different markets is:
– The owners of equity leverage their investments through their business as they borrow a portion of the financing. A company that acquires more has a lesser need for investment. This means that the both losses and profits go to the smaller base, and the proportion of both is multiplied.
– Option and future contracts are securities that work on the notion of short T-bill rates in the borrowing and lending business.
– A company can leverage its operations by fixing their cost inputs. The expected revenues are still variable, and they can go both ways. If the income goes above the average, then the income from operations will add to the overall profit. But if it goes below the average then the services will suffer loss.
– Hedge funds use leverage through the short sale of some positions. Money that is generated through those sales serves as leverage to finance a portion of other portfolios. If those securities fail to make profit, then the loss is twofold, loss from short sales and loss from active portfolios.
– It might not be as obvious as some other things, but individuals use leverage in their financial moves. For example, they leverage their saving by financing a portion of home purchase with a mortgage debt. Another example is the exposure to investments through borrowing from a broker in which cane they leverage their exposure to those investments.
Leverage is all about the management of the risk. A successful investor (trader or any other party that uses leverage in their business) finds a way to lower the possible loss from a business decision that involves leverage. If an investment carries too much risk and the chance of the gain is marginal, then the investor won’t invest. But if the chance of the gain isn’t improbable then the investor can invest and use the leverage to profit from the investment. Possible loss, in that case, is acceptable.
No serious investor will leverage more than they can cover. Those that fail to follow that path of the though end up in bankruptcy. Stock brokers are a good example as they forget about the risk and end up broke over night.
You can find more about this on Wikipedia.
The interest rate is a very important component in the world of finance. Trading markets depend on the change of the interest rate across the world. Many important factors influence the interest rate and following that the interest rate affects many other things along the line. I will try to explain the importance of the interest rate across the financing world.
Many factors influence the interest rate, and the following factors have the strongest influence over it:
– When the consumption of the goods is high, that prompts the increase of the rate of the interest.
– People in the world of finance expect the change of the interest rate due to expectations of the inflation change. Inflation is nothing but a change that makes the goods cost more in the future or the same amount of money being able to purchase fewer goods sometimes down the line.
– Every time a lender lends the money he runs a risk of a borrower who won’t be able to pay it back. And thus the lender has to charge a risk premium which has a slight impact on the interest rate.
– Some types of gain from the interest rate are connected to the taxes and therefore the lenders may try to keep the interest rate high to increase their profit.
– The status of the economy has a great impact on the situation of the interest rate. These two are closely connected. If the economy is strong, the rate is stable as well and vice versa.
– Banks have the big impact on the prices as they can lower or increase them whenever it is necessary. If the economy is too strong, it can damage the country and it is up to the bank to raise the rate. Economic growth can’t be achieved with high-interest rates, so when a country needs it, the bank will lower the price.
– The economy can get a short-run boost with the small lowering of the rates, but this isn’t usually done because the benefits are offset by inflation in short time. In the long run, this type of boost damages the economy. This is still done by many countries due to political reasons. These short-term economy expands more than usually happen just before the election and in a lot of cases; they are the leverage that wins them.
– The state of the economy is reflected in the employment and unemployment. Higher the employment rate the better the economy is. And as I already mentioned, strong economy equals high-interest rate.
Every market that is connected to interest rates has some rules and limitations that protect the biggest investors. Every market has a different level of risk that corresponds to the volume of the impact it has from the changes in the interest rates. The investments and the markets that have increased risks have bigger expectations from the return. On the other hand, the government bonds and similar trading assets that have a low level of risk generate less return.