How Hedge Funds Use Leverage?

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How Hedge Funds Use Leverage?

By Brandon Msimanga

Defining ‘To Hedge’

There are always things in life that we wish we can get rid of, and it so often happens that sooner or later very intelligent people usually not governed by greed, we hope, come up with amazing new discoveries to protect themselves against this probability of a future risk.  It is because people understand the repercussions of uncertainty that they often wish to, in a sense, “eliminate” this risk of change. It would be completely naive of us to think that even with these new gizmos that we are able to destroy the chances of change, as this world is not perfect but it is the balance of perfection and imperfection that allows this planet on its axis peacefully.

Let’s say that we all know, that when winter comes the chances of contracting flu doubles, so when winter begins to strike people get their vaccinations, pull out the heavy duty jackets and their goose-feathered duvets as a precaution of getting flu. Like a safety net. An like everything in life in the finance world we also have many things that have similar characteristics. For instance an insurance policy to take away the financial stress of when an accident stumbles into your way, but none of these things come free. We are after all the finance sector, our main purpose is to make our money grow. So in investment we have also developed certain instruments to take away some of the risk involved with giving up your money to buy an asset that will hopefully yield a return in the future, this is hedging.

To hedge against something is to make an investment to reduce the risk of losing money in the future, due to the fact that price is volatile and is not something that we can control. Hedging is usually used when we are dealing with things that we want to buy or sell in the future. A hedge fund, by definition, is a managed investment portfolio that adapts to different investment strategy positions to reel in a higher profit by gambling with the volatility of future prices. An hedge fund is basically an investment fund that requires a fairly high minimum investment capital and conducted by private entities.

Using the Leverage

Leverage is using borrowed capital or equity for an investment with the expectation that the profits made will be greater than the interest payable. In the investment industry leverage is a very important tool and the Hedge Funds also make use of leverage.

Hedge Funds are currently borrowing more to buy equities and loans via New York Stock Exchange brokers have reached their highest point in four years. This shows that confidence is increasing and confidence levels may be as high as they were in 2008. According to Morgan Stanley leverage among Hedge Fund managers who are speculating increases and decreases in share prices has reached levels that haven’t been seen since at least 2004.

Increased leveraging on the New York Stock Exchange is a positive sign it shows that there is an increase confidence by people such as Hedge Fund managers and the investors that invest in them. It also shows that investors are confident enough to extend credit to Hedge Fund managers with a positive expectation.  One of the requirements that are required for an economy to grow is that investors should have a positive expectation.

However leverage means that Hedge Funds can incur bigger losses if it happens that stocks decline. The risk carries with it some high returns should the market continue to move in the same direction. Hedge Fund managers are betting that record earnings and valuations that are 9.8 percent below the six decade average will help to push the Standard and Poor’s 500 Index toward the record that it set in October 2007.

This will be a very important year for the Hedge Fund industry, investors and Hedge Fund managers alike will be watching the markets very closely. A rise in leverage could be an indication that Hedge Funds and institutional investors are feeling reassured.  A lot of Hedge Funds use leverage to carry long and short positions in excess of their capital. However it is important to note that Hedge Funds do not always make use of leverage.

The downside of the use of too much leverage is that it could have catastrophic effects on the financial system. Leverage can be positively used by Hedge Funds and other firms in the investment industry to multiply profits but on the negative side when losses are incurred with the use of leverage the losses are also multiplied. Some investors are already expressing concerns with the already record high levels of leverage that have not been seen since 2008. It is feared that a drop in stock prices could lead the stock market and the economy spiraling down. This is an important point because some investors are raising and it is important that the levels of leverage that Hedge Funds take on are watched very closely and regulated in order to prevent huge losses being conceded should stock market prices drop sharply.

It is very clear that leverage is a very important and useful tool for Hedge Fund managers but when firms use too much leverage it could cause problems in the financial system. The most successful Hedge Fund managers know exactly when using leverage is advantageous and when it could be a disadvantage.

You may also like learn about risk management in financial institutions, Asset-Liability Management in Banks and career opportunities in risk and asset management.

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One thought on “How Hedge Funds Use Leverage?

  1. November 21, 2015

    Saurabh Mittra Reply

    Very helpful article

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