Leverage is simply a technique to multiply gains and losses.
It basically involves buying more and more of an asset through borrowed funds, with the hope that bought asset will give enough profit to cover the cost of borrowing. In most of the cases the cost of borrowed funds is much larger than appreciation of assets.
RISK:
Leverage increase profits when the returns from the asset is more than the costs of borrowing, losses are magnified when the opposite is true. Bankruptcy can occur for the firm that borrows excess funds, while a less-leveraged corporation might survive.
Brokers may require additional funds when the value of securities hold declines. Banks may fail to renew mortgages when the value of real estate declines. Even if profits are sufficient to maintain the ongoing borrowing costs, loans may be called.
This may happen exactly when there is little market liquidity.
It means that as things get bad, leverage goes up,it multiplies losses as things continue to decline. This can lead to rapid ruin, even if the asset value is declining temporarily. The risk can be mitigated by maintaining unused room for additional borrowing, and by leveraging only liquid assets.
TYPES: Leverage has multiple definitions in respect to some different fields.
1) ACCOUNTING LEVERAGE:- In accounting field leverage means total assets divided by the total assets minus total liabilities.
2) NOTIONAL LEVERAGE:- Notional leverage is total notional amount of assets plus total notional amount of liabilities divided by equity.
3) ECONOMIC LEVERAGE:- It is volatility of equity divided by volatility of an unlevered investment in the same assets.
4) FINANCIAL LEVERAGE:- It is defined as the total debt divided by the shareholder’s equity.
ADVANTAGES:-
1) Magnification of shareholders profits,
2) Improvement in credit rating,
3) Capturing economies of scale,
4) Increases free cash.
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