Measuring Leverage Through Market Exposure and Capital
Summary
The document discusses how to define leverage for risk limits, including cases where assets are pledged to borrow funds and the borrowed proceeds are invested in lower-risk instruments. The proposed definition treats leverage as market exposure, whether long or short, that exceeds the capital required or assigned to support that exposure.
For a conservative exposure measure, it adds the absolute values of long and short positions without credit for diversification or offsets, except for positions in the same asset, then compares the total with supporting capital or margin. For futures, the stated exposure is contract notional at market price divided by margin. The response also describes a Value at Risk based alternative that reflects correlations among assets; its confidence level affects how conservative the resulting measure is. These methods serve risk measurement and limit setting, but the document does not prescribe one universal definition or provide a calculation example.
Key ideas
- Leverage can be measured by comparing market exposure with the capital supporting it.
- A conservative measure adds long and short exposures without allowing most offsets.
- For futures, compare contract notional at market price with required margin.
- A Value at Risk approach can incorporate correlations and a chosen confidence level.
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Full text
# What is Leverage? # What is Leverage? What would you consider leverage? I know this may sound like a basic question but I have spoken with several industry professionals with a significant amount of experience and all of them have a different definition of leverage. There are some that consider collateralized financing and investing in a low risk investment as not leverage. Collateralized financing being borrowing by "lending securities", reverse repo, etc., where one essentially has "pledged" assets to borrow money. And "low risk" investments being money market, commercial paper, treasury bills, etc. It seems to me like this is still leverage, albeit low risk leverage but nevertheless leverage. Should this type of leverage be considered utilization of leverage limits that are defined as a % of capital/assets? Would love to hear various opinions, justification, and theories by various investment professionals. Examples would be appreciated. ## Answer by AlRacoon (score 2) https://quant.stackexchange.com/a/70521 I am going to try to answer my own question: Leverage is any market exposure, long or short, that exceeds the capital required or allotted for the taking of said exposure. A conservative view of market exposure does so without taking into correlation or offsetting exposure, unless the exposure is in the exact same asset. Therefore a short position's market exposure would be the absolute value of the short, and added to the long exposure. This market exposure would be divided by the capital/margin required to support the position to arrive at the leverage. For non-funded positions such as futures, this would be the (notional of the futures contract * price)/margin. The above definition of market exposure may be too conservative and restrictive for some entities which may then choose to use some VAR based approach to determine market exposure. This would then incorporate the correlation between assets. The number of standard deviations or confidence interval for the VAR calculation will help to arrive at more or less conservative measure of market exposure. For risk measurement and management purposes, both of these measures would prove useful.
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