In other words, leverage is any financial mechanism used to increase the potential return per unit of amount invested, by magnifying the risk exposure at the same time.
Leverage comes in three main forms. Traditionally, leverage is understood as the use of borrowed funds to increase the size of assets under control. Beyond traditional leverage, economic leverage is also widely used. Economic leverage denotes the inclusion of assets with internal leverage in the portfolio (instrument leverage).
Since these assets are notionally funded, it is possible to control a larger amount of the underlying position with a small initial investment/ margin. Beyond these, using a third form of leverage, which is referred to as “construction leverage,” is also observable.
This term refers to the practice of combining certain long and short positions of assets with preferably high correlation, thus eliminating market risk (at least in part). By using this methodology, fund managers are targeting idiosyncratic risk with a relatively small initial investment.
Measuring the degree of leverage is not an easy task. As for the traditional form of leverage, it measures the ratio between interest bearing debt and equity within the balance sheet.
The effect of paying fixed debt costs will magnify the volatility of the (after-tax) earnings per unit of capital invested—this is also known as leverage effect. Certainly, the use of borrowed funds is, as a rule, efi cient if the gains are higher than the fixed costs of borrowing.
As for economic and construction leverage, the degree of leverage characterizes the ratio between the size off(or investment in) the initial position and the total value of the underlying controlled through this position.
The leverage effect denotes in this case that, when investing in such assets, changes in the market value of the underlying position might lead to disproportional changes in the value of the derivative position.
Note that leverage generates return distributions with inherent non-normality. This is so since by using leverage the underlying return distribution will be capped and part of this risk is transferred to other market participants (debt holders, option writers, etc.), thus creating an option-like characteristic in every case.