Thursday, March 09, 2006

Financial Leverage

In general, financial leverage results from having control over an asset (read, getting gains and losses from) an asset that you don't own (yet). I'll give you the two examples that I gave in section:

1. I own a condominium in Harvard Square. This condominium cost about $400,000. If my property value increases by 5%, I realize a gain of 5% of the entire value of the condo, or $20,000. However, I did not pay $400,000 up front for the condo, I instead made a down payment and took a mortgage on the property. Thus I have control over the asset that I don't yet own outright. Say I put down $20,000 on the property. Then the 5% property value increase that I mentioned would actually be a return of 100% on my initial investment. Generally, financial leverage is characterized by higher percentage gains and losses than owning an asset outright. (If property value dropped by 5%, I would realize a 100% loss on my initial investment)

2. Say you have $500 to spend on financial assets. There is a stock that you are interested in that is trading at $50, and call options on this stock (with a strike price of $50) are trading at $5. Therefore, you can either buy 10 shares of stock or 100 options on the stock. Say the price of the stock goes up to $60. If you own the stock, you make $100, or 20% of your investment. If you own the options, you make $1000-$500 (the cost of the options)=$500, or 100% of your investment. Conversely, say the stock drops to $40. If you own the stock, you lose $100, or 20%. (This is only a loss on paper technically unless you are actually forced to sell the stock.) If you own the options, they are worthless (assuming they expire today) and you have a loss of 100% of your investment.


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