Leverage impact Essay

345 WordsMar 27, 20092 Pages
Leverage Leverage is a very powerful tool, which can multiply significantly returns, but also magnifies the risks undertaken. Through leverage institutions can increase their exposure to an underlying asset, as well as the losses in case of adverse market conditions. It is therefore important to understand the risks involved and how these can be measured Leverage can be categorized into balance-sheet, economic and embedded leverage. The first type is easily observable from the bank’s books and refers to borrowings, while the economic leverage also comprises off-balance sheet items, such as loan guarantees, derivatives, and securitized loans. To assess the overall risk, a replicating balance sheet is drawn up to include exposure from all items, found both in and off the balance sheet. Embedded leverage is the hardest to evaluate, as it cannot be found in financial data and refers to exposures in non-consolidated stakes. To get a realistic picture of the leverage used by an entity and consequently manage the risks associated to it, all three types of leverage should be considered. However, one of the problems that arise is how to find embedded leverage. This is a very difficult task, since the information available is not transparent and not readily available. Ignoring this risk however can be dangerous. One of the major issues related to leverage is the liquidity and counter-party risks, which are introduced with leverage. The importance of these risks is obvious if we consider the consequences of the present crisis. During financial distress liquidity is immediately wiped out, making it hard for borrowers to close their positions. In a leveraged position, both the short and long positions should be closed, which can actually be impossible in an illiquid market. The counter-party risk is also an issues, since the default of one party immediately triggers the

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