Loan and Derivative Methods for Leveraging an Equity Position
Summary
The document outlines two broad ways to gain leveraged exposure to an underlying security. Loan based approaches use the purchased asset as collateral, as with a broker margin loan; bond traders also use repo financing. These methods involve borrowing against collateral and typically apply a haircut, so the loan is smaller than the collateral’s value.
Derivative based approaches provide exposure through contracts such as futures and total return swaps, with margin posted instead of paying the full asset value. Options can also create leverage, though their nonlinear payoff may be unnecessary when constant exposure is the goal. The response says daily leveraged exchange traded funds mainly use futures and total return swaps. It gives a high level taxonomy rather than comparing financing costs, risks, contract terms, or leverage outcomes; the appropriate method depends on those details.
Key ideas
- Collateral loans, including margin loans and repo, create leverage through borrowing against assets.
- Futures and total return swaps provide exposure through contracts with margin requirements.
- Options can create leveraged exposure but their payoff is nonlinear.
- Daily leveraged ETFs mainly obtain exposure using futures and total return swaps.
- The document does not compare costs, collateral rules, or product specific risks.
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Full text
# What are the various methods that can be used to acheive a leveraged position of an underlying security? # What are the various methods that can be used to acheive a leveraged position of an underlying security? Looking for a comprehensive list of the different ways one can leverage a stock position and the pros/cons of the various methods. Some basic ways I'm familiar with: 1.Borrow at some fixed rate against other assets. 2.Buy deep in the money calls with a high Delta. 3.Buy the call at the money while selling the put. What are other perhaps more sophisticated ways of achieving leverage. Of course I could also buy daily leveraged ETFs but I would like to understand how exactly the managers are acheiving this leverage. Thank you. ## Answer by nbbo2 (score 3, accepted) https://quant.stackexchange.com/a/79875 Generally there are 2 ways to achieve leverage: - In Loan Based Methods, the security being purchased is used as collateral for a loan (subject to a haircut i.e. the loan amount is less than the value of the security). The Margin Loan from a stock broker is an example, or the Repo technique used by bond traders in government bond markets. - In Derivatives based methods a separate market is set up to provide leverage (in both directions) to traders who desire it. The Futures markets (established in 19th century in US and UK, even earlier in Japan) are the main example. A more recent example is TRS (Total Return Swaps). In these cases you do not trade the security itself but a contract based on the security. Both sides will have to provide some cash (aka margin) to enter the contract but this will be less than the full value of the security. Essentially one side agrees to pay a multiple of the price change when the asset goes up and expects to receive the same multiple of the the loss from the other side when the asset goes down. They are like two bettors on a football game, one hopes the DownTeam wins the match and the other the UpTeam. Options are another example of a leveraged derivative, but their complexity/nonlinearity is unnecessary if you just need constant leverage. Daily leveraged ETF's mainly use futures and TRS.
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