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What Is the Connection between Financial Leverage and Risk?

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  • Written By: Geri Terzo
  • Edited By: PJP Schroeder
  • Last Modified Date: 26 August 2016
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    Conjecture Corporation
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The very act of tacking on leverage to an investment is in fact introducing risk to a transaction. Risk lies in the fact that, if a loss occurs, the deficit becomes magnified based on the ratio of leverage, or debt, added to the trade. By the same token, if the trade is successful, the rewards are similarly amplified. Investors apply trading strategies that determine the association or relationship between financial leverage and risk.

Financial leverage and risk are inherently linked to one another. In the financial services arena, placing leverage on a transaction, such as betting that a stock will advance or decline, is to borrow from some broker to potentially increase the returns, or profits, achieved on the trade. The ratio of leverage and risk can be determined based on the size of the loan in relation to the value of total assets overseen by an investor.

Hedge funds, which are lightly regulated investment vehicles run by professionals, are frequent participants in piling leverage and, subsequently, risk onto trades. Managers of these funds often rely on prime brokers in order to borrow shares when performing an investment transaction. The amount of shares that are extended by a broker may be based on the amount of money that a hedge fund manager oversees in addition to policies that might be part of the broker organization. Historically, larger hedge funds use the most financial leverage in comparison with smaller funds.

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Financial leverage and risk are not limited to the party making the trade, such as the hedge fund. If the transaction goes bad and the hedge fund is not in a position to repay the amount borrowed, the prime broker becomes exposed to a loss. Prime brokers will typically go to great lengths to examine a client's performance history and access to capital, also known as liquidity, prior to lending shares in order to protect themselves from loss.

Also at play is the type of strategy pursued by a hedge fund. Betting with leverage that two stocks in different industries will move in counter directions is more risky than placing a bet that a pair of competing stocks will make similar moves. This is because two stocks in the same industry have a better chance of trading and offsetting the other in comparison with a pair of securities in completely different segments of the economy.

The amount of financial leverage and risk are closely linked. For instance, the greater the amount of debt added to a transaction, the higher and greater the chance for loss becomes. There are some ratios of financial leverage that are less precarious than others, but the amount of risk taken on is also dependent on the experience and sophistication of the investor.

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