Leverage has been responsible for some of the most glamorous gains and disastrous declines in the financial world. Here we look at what leverage is, and show an example of its devastating potential.
What is Leverage?
Leverage is typically defined as your “exposure” relative to “actual capital”.
Where exposure is the value of your holdings, and actual capital is money paid or invested by you. The additional “exposure” comes from borrowed money, and this is why being “leveraged up” can be so dangerous.
In the most general terms, leverage is:
The most common form of leverage that consumers are familiar with deals with mortgages. Consider a family looking to purchase a $500,000 house. They likely cannot afford to write a $500,000 check. They will most likely go to a bank and put, say, $100,000 down and take out a mortgage for the remaining $400,000.
Here the family’s “exposure” is $500,000, the actual value of their house, but their “actual capital” is just the $100,000 they put down. [continue reading…]