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Definition of Leverage

Leverage, in a financial context, refers to the use of borrowed funds or debt to amplify the potential return on an investment. It allows an investor or a company to control a more substantial asset or investment than would be possible using only their own capital.

While leverage can magnify gains, it also increases the risk of losses, as the borrowed funds need to be repaid regardless of the investment's performance.

The concept of leverage is widely used in various financial transactions, including trading on margin, real estate investments, and corporate finance.

What is Leverage?

Leverage is a financial strategy that involves using borrowed capital to increase the potential return on investment. By leveraging funds, investors or companies can take on larger positions or investments than their available cash would allow.

The idea behind leverage is to use the borrowed funds to generate higher profits than the cost of borrowing, thereby enhancing overall returns.

Leverage is not limited to borrowing money but can also involve financial instruments like options and futures that provide exposure to larger positions with a smaller initial investment.

However, it's essential to recognize that leverage comes with increased risk, as losses can be magnified when investments perform poorly.

What are examples of Leverage?

Several examples illustrate the concept of leverage in different financial scenarios:

Margin Trading

An investor buys $10,000 worth of stocks using $5,000 of their own money and $5,000 borrowed from a brokerage.

If the stock's value increases, the investor's return is amplified, but if it declines, losses are also magnified.

Real Estate Investment

A real estate investor purchases a property using a combination of their funds and a mortgage loan from a bank.

The rental income generated from the property exceeds the mortgage interest, resulting in positive cash flow and a higher return on investment.

Corporate Debt

A company issues bonds to raise funds for expansion. The interest paid on the bonds is lower than the return generated from the invested capital, allowing the company to increase its overall profitability.

Derivatives Trading

A trader buys call options on a stock, gaining exposure to a more substantial position than they could with direct stock purchase.

If the stock price rises, the trader benefits from amplified gains through the options' leverage.

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