Leverage is among the most defining features of any hedge fund. Therefore, hedge funds have gained expertise in the buildup and usefulness of leverage. They don’t only use traditional means like equity and fixed income leverage but they also use leverage with the help of futures, options, and swaps. In this article, we’ll discuss how this leverage is exploited and used to the advantage of hedge funds.
Using equity shares to create leverage is one of the oldest and simplest ways used by hedge funds. The idea is useful when the fund wants to solely invest in stocks. The typically buys stocks and then uses the same stock as collateral to borrow even more and buy even more stocks.
The borrowing against a stock is normally done in the form of a “repo” or repurchase agreement. This means that the borrower sell their stock worth $100 to the lender. The same borrower promises to buyback the share at $101 per week from now.
Therefore, the $1 is effectively an interest paid on the $100. On the other hand, the title of the shares changes hands. This is to enable a lender to sell the shares without any legal hassles in case the borrower is unable to pay back the borrowed amount plus interest.
Fixed Income Leverage
Fixed income leverage is very much similar to equity leverage. The only difference is that the securities being used as collateral are fixed income securities like US Treasury bonds. The securities do not change in value as quickly as equities, and that means they are considerably less volatile. This makes the lender offer a very high loan to value ratio.
Thus, when hedge funds are creating positions in fixed income securities, they can borrow the money against the existing securities they are holding and magnify their positions. Once again the need for coordination by a lender as well as the transaction costs involved act as deterrent.
Derivatives such as futures that trade on an exchange give hedge funds a chance to create leverage. Futures allow hedge funds to take big positions using only 10 percent of capital as margin money. The movement s of the market are tracked and the margin needs to be added into the account in case the price of the security dips down.
On the other hand, the good side is that since the lending of the money is brokered by an exchange, the process happens so smoothly without any hiccups. In addition, the transaction costs are minimal and the margin mechanism is perfect. The presence of a liquid secondary market is a great boon for these hedge funds. They can liquidate their positions as and when they want.
Options are also traded on the exchange. This gives traders an opportunity to magnify their leverage without putting in much capital. For example, if a fund buys an option worth $10, this would give them the same amount of control as $1000 would if they were to buy the shares outright. This is because options give traders the right but not the obligation to make a purchase at a given price.