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Leverage and its impact on financing markets

Leverage and its impact on financing markets

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.

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