Leverage (finance)

In finance, leverage, also known as gearing, is any technique involving borrowing funds to buy an investment.

Financial leverage is named after a lever in physics, which amplifies a small input force into a greater output force, because successful leverage amplifies the smaller amounts of money needed for borrowing into large amounts of profit. However, the technique also involves the high risk of not being able to pay back a large loan. Normally, a lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan.

Leveraging enables gains to be multiplied.^[1] On the other hand, losses are also multiplied, and there is a risk that leveraging will result in a loss if financing costs exceed the income from the asset, or the value of the asset falls.

Leverage can arise in a number of situations. Securities like options and futures are effectively leveraged bets between parties where the principal is implicitly borrowed and lent at interest rates of very short treasury bills.^[2] Equity owners of businesses leverage their investment by having the business borrow a portion of its needed financing. The more it borrows, the less equity it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.^[3] Businesses leverage their operations by using fixed cost inputs when revenues are expected to be variable. An increase in revenue will result in a larger increase in operating profit.^[4][5] Hedge funds may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.