Module XII·Article I·~3 min read
Types of Leverage
Leverage, Collateral, and Lombard Loans
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Types of Leverage
Financial leverage: types and mechanics
Leverage (financial leverage) is the use of borrowed funds to increase exposure to assets. Proper use of leverage can improve returns, but amplifies both profits and losses.
Types of leverage
| Type | Mechanics | Lender | Typical LTV | Application |
|---|---|---|---|---|
| Margin (brokerage) | Broker provides credit for positions on account | Broker | 50-70% | Trading stocks, futures |
| Lombard credit | Bank lends against collateral of portfolio | Bank | 50-80% | Liquidity for UHNW, family offices |
| REPO | Sale with obligation to repurchase | Counterparty (dealer) | 95-98% | Institutional funding |
| Prime Brokerage | Comprehensive services for hedge funds | Investment bank | 40-80% | Hedge funds |
| Structured Products | Embedded leverage via derivatives | Issuer | Varies | Retail, HNWI |
Leverage effect: mathematics
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\text{Leveraged Return} = (\text{Asset Return} \times \text{Leverage}) - (\text{Borrowing Cost} \times (\text{Leverage} - 1))
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Example: 2x leverage
| Scenario | Asset Return | Unleveraged | 2x Leveraged (after cost 5%) |
|---|---|---|---|
| Bull case | +20% | +20% | +35% |
| Base case | +8% | +8% | +11% |
| Bear case | -15% | -15% | -35% |
| Crash | -40% | -40% | -85% |
Key takeaway:
Leverage is a double-edged sword. 2x leverage turns a -40% drawdown into nearly a total loss of capital.
Margin Trading: Regulation T
In the USA, brokerage margin is regulated by Regulation T:
| Parameter | Requirement |
|---|---|
| Initial Margin | 50% (can buy stocks for 2x your equity) |
| Maintenance Margin | 25% (FINRA), often 30-35% at brokers |
| Margin Call | When equity falls below maintenance |
Lombard Credit: structure
Lombard – a private bank loan secured by an investment portfolio:
| Parameter | Characteristic |
|---|---|
| Collateral | Diversified portfolio (stocks, bonds, funds) |
| LTV | 50-70% (depends on asset quality) |
| Rate | SOFR + 1-2% (for premium clients) |
| Purpose | Any (liquidity, real estate, tax bridge) |
| Term | Usually revolving (evergreen) |
REPO: institutional standard
Repurchase Agreement (REPO) – sale of securities with obligation to repurchase:
- Seller (borrower) sells securities to the buyer (lender)
- Receives cash
- Obligates to repurchase at a higher price (repo rate)
| Parameter | Treasuries Repo | Corporate Bonds Repo | Equity Repo |
|---|---|---|---|
| Haircut | 1-2% | 5-15% | 15-30% |
| Repo Rate | Fed Funds ± 5bp | +25-50bp | +100-200bp |
| Term | O/N to 3M | O/N to 1M | O/N to 1W |
Leverage Ratios for CIO monitoring
| Metric | Formula | Safe level | Dangerous level |
|---|---|---|---|
| Gross Leverage | Long + | Short | / NAV |
| Net Leverage | (Long - | Short | ) / NAV |
| Debt/Equity | Total Debt / Equity | > 2x | |
| Interest Coverage | EBITDA / Interest | > 3x |
CIO recommendations for leverage usage
- Match leverage to asset volatility — the more volatile the asset, the lower the leverage
- Stress test — model -30%, -50% drawdown scenarios
- Liquidity buffer — keep reserves for margin calls
- Diversify lenders — do not depend on a single creditor
- Understand terms — read covenants and termination clauses
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