Financial leverage

In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is any technique involving the use of borrowed funds in the purchase of an asset, with the expectation that the after tax income from the asset and asset price appreciation will exceed the borrowing cost. Normally, the finance provider would set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan. For example, for a residential property the finance provider may lend up to, say, 80% of the property's market value, for a commercial property it may be 70%, while on shares it may lend up to, say, 60% or none at all on some shares.

Leveraging enables gains and losses to be multiplied. On the other hand, there is a risk that leveraging will result in a loss — ie., it actually turns out that financing costs exceed the income from the asset, or because the value of the asset has fallen.

Leverage can arise in a number of situations, such as:

While leverage magnifies profits when the returns from the asset more than offset the costs of borrowing, leverage may also magnify losses. A corporation that borrows too much money might face bankruptcy or default during a business downturn, while a less-leveraged corporation might survive. An investor who buys a stock on 50% margin will lose 40% of the money invested if the stock declines 20%.

Risk may be attributed to a loss in value of collateral assets. Brokers may require the addition of funds when the value of securities hold declines. Banks may fail to renew mortgages when the value of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to maintain the ongoing borrowing costs, loans may be called.

This may happen exactly when there is little market liquidity and sales by others are depressing prices. It means that as things get bad, leverage goes up, multiplying losses as things continue to go down. This can lead to rapid ruin, even if the underlying asset value decline is mild or temporary. The risk can be mitigated by negotiating the terms of leverage, by maintaining unused room for additional borrowing, and by leveraging only liquid assets.

On the other hand, the extreme level of leverage afforded in forex trading presents relatively low risk per unit due to its relative stability when compared with other markets. Compared with other trading markets, forex traders must trade a much higher volume of units in order to make any considerable profit. For example, many brokers offer 100:1 leverage for investors, meaning that someone bringing $1,000 can control $100,000 while taking responsibility for any losses or gains their investments incur. This intense level of leverage presents equal parts risk and reward.

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