What is Leverage?
Leverage is the strategic use of borrowed capital or debt to increase the potential return on investment. It allows individuals and businesses to amplify their gains and losses by using borrowed funds to invest in assets. Understanding how leverage works is essential for investors to make informed decisions about risk management and capital allocation.
Types of Leverage
- Financial Leverage: This involves using debt to finance investments in order to increase the potential return on equity.
- Operating Leverage: This refers to the fixed costs a company incurs, which can magnify profits when revenue increases but also expose the business to risk when sales decline.
Examples of Leverage
For example, a real estate investor may use a mortgage to buy a rental property, with the goal of generating rental income that exceeds the cost of the loan. In this case, the leverage ratio is the amount of debt compared to the value of the property.
Case Studies
One famous case of leverage gone wrong is the bankruptcy of Lehman Brothers in 2008. The investment bank took on too much leverage in mortgage-backed securities, which led to its collapse and triggered a global financial crisis.
Statistics on Leverage
According to a study by the Federal Reserve, leverage in the financial industry has been increasing steadily over the past decade, raising concerns about systemic risk and the potential for another financial crisis.
