Definitions of leverage and of leverage factor
From investopedia
Here's an example of a "yen carry trade": a trader borrows 1,000
Japanese yen from a Japanese bank, converts the funds into U.S.
dollars and buys a bond for the equivalent amount. Let's assume that
the bond pays 4.5% and the Japanese interest rate is set at 0%. The
trader stands to make a profit of 4.5% as long as the exchange rate
between the countries does not change. Many professional traders use
this trade because the gains can become very large when leverage is
taken into consideration. If the trader in our example uses a common
leverage factor of 10:1, then she can stand to make a profit of 45%.
I was wondering how leverage and leverage factor are defined?
For leverage factor, from another source
The capital for the investment comes from equity and debt, and the
amount of the debt divided by the total capital is the leverage
factor.
it seems like different from the one used in investopedia. The
latter, I guess, is the ratio of the debt to the equity?
Also what does leverage ratio of a bank mean in the following
quote:
In 2008 typical leverage ratios were
Commercial banks: 10 to 1
Investment banks: 30 to 1
Thanks and regards!
(3)3 Comments
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Levarge in simple terms is how of your own money to how much of borrowed money.
So in 2008 Typical leverage ratios were Investment Banks 30:1 means that for every 1 Unit of Banks money [shareholders capital/ long term debts] there was 30 Units of borrowed money [from deposits/for other institutions/etc]. This is a very unstable situation as typically say you lent out 31 to someone else, half way through repayments, the depositors and other lends are asking you 30 back. You are sunk. Now lets say if you lent 31 to some one, but 30 was your moeny and 1 was from deposits/etc. Then you can anytime more easily pay back the 1 to the depositor.
In day trading, usually one squares away the position the same day or within a short period. Hence say you want to buy something worth 1000 in the morning and are selling it say the same day. You are expecting the price to by 1005 and a gain 5. Now when you buy via your broker/trader, you may not be required to pay 1000. Normally one just needs to pay a margin money, typically 10% [varies from market to market, country to country]. So in the first case if you put 1000 and get by 5, you made a profit of 0.5%. However if you were to pay only 10 as margin money [rest 990 is assumed loan from your broker]. You sell at 1005, the broker deducts his 990, and you get 15. So technically on 10 you have made 5 more, ie 50% returns. So this is leveraging of 10:1. If say your broker allowed only 5% margin money, then you just need to pay 5 for the 1000 trade, get back 5. You have made a 100% profit, but the leveraging is 20:1.
Now lets say at this high leveraging when you are selling you get only 990. So you still owe the broker 5, if you can't pay-up and if lot of other such people can't pay-up, then the broker will also go bankrupt and there is a huge risk.
Hence although leveraging helps in quite a few cases, there is always an associated risk when things go wrong badly.
This would clear out a lot more.
1) Leverage is the act of taking on debt in lieu of the equity you hold. Not always related to firms, it applies to personal situations too. When you take a loan, you get a certain %age of the loan, the bank establishes your equity by looking at your past financial records and then decides the amount it is going to lend, deciding on the safest leverage. In the current action leverage is the whole act of borrowing yen and profiting from it. The leverage factor mentions the amount of leverage happening. 10000 yen being borrowed with an equity of 1000 yen.
2) Commercial banks: 10 to 1 -> They don't deal in complicated investments, derivatives except for hedging, and are under stricter controls of the government. They have to have certain amount of liquidity and can loan out the rest for business.
Investment banks: 30 to 1 -> Their main idea is making money and trade heavily. Their deposits are limited by the amount clients have deposited. And as their main motive is to get maximum returns from the available amount, they trade heavily. Derivatives, one of the instruments, are structured on underlyings and sometimes in multiple layers which build up quite a bit of leverage. And all of the trades happen on margins. You don't invest k to buy k of a traded stock. You put in, maybe 0 to take up the position and borrow the rest of the amount per se. It improves liquidity in the markets and increases efficiency. Else you could do only with what you have. So these margins add up to the leverage the bank is taking on.
Your original example is a little confusing because just shorting for 1k and buying for 1k is 100% leveraged or an infinitive leverage ratio. (and not allowed)
Brokerage houses would require you to invest some capital in the trade. One example might be requiring you to hold 0 in the brokerage. This is where the 10:1 ratio comes from. (1000/10)
Thus a return of 4.5% on the 1000k bond and no movement on the short position would net you and voila a 45% return on your 0 investment.
A 40 to 1 leverage ratio would mean that you would only have to invest to make this trade. Something that no individual investor are allowed to do, but for some reason some financial firms have been able to.
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