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Leverage as a measure of risk

D. L. Chertok†
January 20, 2009

SUMMARY
Leverage is treated as a measure of risk factor sensitivity. It can be computed
using the “equivalent security” approach to determine “bucketized risk”.

1 Justification
The unfolding financial crisis has brought the issue of leverage into the lime-
light. ”Overleveraging” is often blamed for the demise of structured finance
yet the issue is often viewed from the traditional, purely accounting standpoint.
This technical note expands the concept of leverage to derivative products and
provides a tool for assessing its impact when the ”traditional” approach does
not work. The intended audience is non-technical practitioners interested in
controlling portfolio risks associated with leverage.

2 Accounting and risk-based leverage


Accounting leverage can be defined as
assets assets
L = = . (1)
max{equity, 0} max{assets − liabilities, 0}

It follows from Eq. (1) that as the value of liabilities approaches that of assets,
the leverage of the portfolio grows infinitely. This is not an unduly restrictive
assumption for traditional portfolios since in this case the liquidation of the
portfolio (e.g., due to bankruptcy) is a rational consequence.
Let us illustrate this with an example.

Example 1 Suppose that you bought a house last year for $500,000 with $50,000
as a down payment. Considering this house as a self-contained real estate port-
folio, its assets last year were $500,000, its equity portion ( total assets less
† D. L. Chertok, Ph.D., CFA, is a quantitative investment professional. He can be reached

by e-mail @ daniel chertok@hotmail.com or by telephone @ (847) 962-9878.

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liabilities ) was $50,000, so its accounting leverage was $500,000
$50,000 = 10. If the
value of your house this year grows by 10% to $550,000, your equity increases
by 100% to $100,000. If your house value drops to $450,000, your equity de-
creases by 100% ( disappears ).
50,000
In this example, a 10% return on assets ( ROA ) ( 500,000 = 10% ) results in a
−50,000
100% return on equity( ROE ), and a -10% ROA ( 500,000 = −10% ) yields a
-100% ROE. From ( 1 ),
P &L(t0 ,t1 ) change in equity(t0 ,t1 )
assets(t0 ) equity(t0 ) equity(t0 ) ROE
L(t0 ) = = P &L(t0 ,t1 )
= change in assets(t0 ,t1 )
= , (2)
equity(t0 ) ROA
assets(t0 ) assets(t0 )

which gives us an alternative definition of leverage. Note here that this definition
only makes sense under the going concern assumptions, i.e., in situations where
the portfolio has sufficient equity to prevent liquidation. In fact, if your house
value increases to $550,000 ( and your debt doesn’t change ), your leverage falls
550,000
to 550,000−450,000 = 5.5. If your house value decreases to $450,000 ( or less )
450,000
under the same assumptions, your leverage becomes infinite: 450,000−450,000 =
∞, and ( 2 ) becomes meaningless.
Example 2 ( see [1] ) Suppose you bought a 3-month European call option
struck at $80 on a stock currently trading at $75. Here the underlying stock
plays the role of an asset and the call itself plays the role of equity. Assuming
( annualized ) implied volatility of 20% and simple 3-month risk-free rate at
0.1%, the price of this call is $1.22 and its delta is ∆ = 0.28 1 . Accounting
leverage as defined by ( 1 ) is equal to 1, since you bought the option with your
own money. Risk-based leverage defined by ( 2 ), however, is
change in equity(t0 ,t1 )
equity assets 75
L(t0 ) = change in assets(t0 ,t1 )
=∆ = 0.28 = 17 , (3)
equity 1.22
assets
$2
which makes sense: a $75 = 2.7% change in the ( underlying ) asset price leads
$0.55
to a $1.22 = 45% change in equity, and the ratio of the second to the first is 17.
Clearly, any reference to ”borrowed money” is irrelevant in this case.
Summarizing,
• accounting leverage is irrelevant to derivative securities as a measure of
risk;
• risk-based leverage captures risk better than accounting leverage;
• risk-based leverage yields the same result as accounting leverage for ”tra-
ditional” assets;
• risk-based leverage is a dynamic measure, i.e., it requires that asset and
equity P&L be known, whereas accounting leverage is a static measure
not requiring such knowledge.
1 For a detailed calculation see Appendix A.

2
3 Application of risk-based leverage to portfolio
management
As follows from Section 2, risk-based leverage, and not accounting leverage, is an
appropriate measure for a portfolio that includes derivative products ( futures,
swaps, options and other exotics ). In this case, ”equity” is the current portfolio
net asset value ( NAV ). It is unclear, however, how ”assets” can be defined in
the case of a complex portfolio. A case can be made for the following algorithm:
• select an easy-to-analyze ”equivalent ( non-derivative ) security” from
some intuitive considerations, e.g., a bond with the same duration as the
portfolio or a 10-yr Treasury note;
• calculate DV01 of the equivalent security per $1 notional:

P V$1 (curveup10b.p. ) − P V$1 (curvedown10b.p. )


DV 01eq. sec. = (4)
20

• find a ”perfect hedge” for the portfolio in terms of the equivalent security,
i.e., find the notional amount of this security that has the same DV01 as
our portfolio, i.e.,
DV 01port
Neq.sec = (5)
DV 01eq.sec.

• the amount of assets required for ( 2 ) is equal to the notional amount


found above.

Example 3 Suppose that portfolio DV01 is DV 01port = $500,000 which is cal-


culated by moving the interest rate curve ( assuming that we are only concerned
with one currency ) up and down by 10 b.p. Suppose further that DV01 of a
10-year Treasury note is DV 01T Y ($1) = $0.001 per $1 notional. Then the equiv-
DV 01
alent assets will be DV 01T port
Y ($1)
= 500,000
0.001 = $500,000,000. If the current value
$500,000,000
of the portfolio is $50,000,000, then equivalent risk-based leverage is $50,000,000
= 10.

Clearly, any number of equivalent assets can be used to calculate portfolio


leverage in the general case. One could expand the definition in ( 2 ) to include
leverage with respect to a collection of ”base assets”,e.g., 2, 3, 5, 10 and 30-year
( on-the-run ) Treasury notes. If it is possible to construct a unique portfolio
decomposition as presented by ( 4 ) – ( 5 ), one can perform ”sensitivity
analysis” with respect to each equivalent security separately. Such analysis
would capture ”bucketized risk”,i.e., exposure to different parts of the interest
rate curve. Using an equivalent asset approach yields a more comprehensive
picture of the overall portfolio risk compared to the one painted by accounting
leverage.

3
Appendix A Calculation of option price and ∆
in Example 1
The Black-Scholes equation for the call price ( see, e.g., [2] ) yields:

c = SN (d1 ) − Ke−rT N (d2 ) , (A.1)


S
  2

ln K + r + σ2 T
d1 = √ , (A.2)
σ T

d2 = d1 − σ T , (A.3)
Z x
1 y2
N (x) = √ e− 2 dy , (A.4)
2π −∞
where

c - call price,
S - spot price of the underlying stock = 75,
N - cumulative distribution function of the standard normal distribution,
K - call strike = 80,
r - simple 3-month risk-free rate = 0.1% = 0.001,
T - time to option expiry in years = 0.25,
σ - volatility of the price of the underlying stock = 20% = 0.2.

∂c
Differentiating ( A.1 ) - ( A.4 ) with respect to S, we obtain ∂S = ∆ = N (d1 ).
Substituting the numbers from Ex. 1 into ( A.1 ) - ( A.4 ), we obtain c = 1.22
and ∆ = 0.28.

References
[1] D. Goldman. Seeing is not believing: Fund of funds and hedge fund risk as-
sessment and transparency, survival and leverage. Working paper, Measurisk
TM
, 2003.
[2] J. Hull. Options, Futures and Other Derivatives. Prentice Hall, 6th edition,
2006.