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Leverage is one of the defining features of any hedge fund. Therefore hedge funds have gained expertise in the creation and utilization of leverage.
Not only do they use traditional means like equity and fixed income leverage but they also use create leverage with the help of futures, options and swaps. In this article, we will explain how this leverage is created.
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 exclusively invest in stocks. The fund usually purchases stock and then uses the same stock as collateral to borrow even more and purchase even more stock!
The borrowing against stock is usually 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 a week from now. Hence, the $1 is effectively an interest paid on the $100.
However, in the meantime the title of the shares changes hands. This is to allow the lender to sell the shares without any legal hassles in case the borrower is unable to pay back the borrowed amount plus interest.
The lender also holds on to some margin money. This margin money is revised as the value of the stock changes. Failure to put up the required collateral during a margin call can lead the lender to sell the stock and liquidate their position.
This technique is used infrequently given that it requires the help of a lender. Also, the transaction costs involved in the equity leverage technique are significant and act as a deterrent.
Fixed income leverage is very similar to equity leverage. The only difference is that the securities being used as collateral are fixed income securities like US Treasury bonds.
Now, these securities do not change in value as quickly as equities. Therefore they are considerably less volatile and as a result lender will offer a very high loan to value ratio.
Hence, when hedge funds are creating positions in fixed income securities, they can borrow money against the existing securities that they hold and magnify their position. Once again the need of coordination by a lender as well as the transaction costs involved act as a deterrent.
Derivatives like futures which trade on the exchange provide an opportunity for hedge funds to create leverage. Futures allow hedge funds to take large positions using only 10% of the capital as margin money. The movements of the market are tracked and margin needs to be added into the account in case the price of the security goes down.
However, the upside is that since the lending of money is brokered by the exchange, the process happens smoothly without any hiccups. Also, 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 at a minute’s notice.
Futures therefore present an opportunity for the fund to create a 9:1 leverage without having to pawn the shares as collateral over and over again.
Options are also traded on the exchange. This gives traders an opportunity to magnify their leverage without putting in much capital. For instance if a fund were to buy an option worth $10, this would give them the same amount of control as $1000 would if they were to purchase the shares outright. This is because options provide traders with the right to but not the obligation to make a purchase at a given price. If the price of the stock does not rise high enough, the trader simply writes off the $10 investment in the option price. The fund could also use put options to create a right to but not an obligation to sell their shares at a pre-determined price. Once again, if they do not want to sell the underlying shares they have to write off the cost of the option.
Hedge funds can therefore take massive positions in stocks, bonds and various underlying commodities with the help of options without actually buying any of those commodities. Moreover options do not have to be reported on the balance sheet. Therefore fund managers can create leverage without making the balance sheet look too bad.
Swaps, just like options, are built on a notional amount. This means that when a contract is entered into almost no cash changes hands. In an interest rate swap one party agrees to exchange their fixed rate interest with floating rate interest on a certain date. The notional amount could be set at a million dollars. Therefore even though neither party has put down a million dollars, they will be liable to pay the interest rate on the same to another party!
This is how hedge funds create massive amounts of leverage. Once again derivatives do not have to be listed on the balance sheet and therefore are preferred by the hedge funds.
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