Leverage (finance) - Leverage and Risk

Leverage and Risk

The most obvious risk of leverage is that it multiplies losses. A corporation that borrows too much money might face bankruptcy or default during a business downturn, while a less-levered corporation might survive. An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%.

There is an important implicit assumption in that account, however, which is that the underlying levered asset is the same as the unlevered one. If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diversification might more than offset the additional risk from leverage. Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, with a limited downside. So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly-levered hedge funds have less return volatility than unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than unlevered technology companies.