Who says there are no free lunches? You just need the skill of pulling the right lever at the right time. Take the case of our friend Johnny. Whenever he invites a new friend for lunch, he ensures that one of his old friends also comes along. The new friend enjoys the free lunch and thanks Johnny whereas the old friend pays the bill. A day will come when this lunch table will complete a full circle and this new friend will be paying for the lunch of some other new friend of Johnny. But Johnny, who brings the old and new friends together, will always enjoy a free lunch. Johnny is leveraging a free lunch out of his networking skills to his advantage. But what Johnny is doing is pretty small compared with what others are doing with leveraged money in the financial markets.
Johnny: Leverage? I have read this term so many times in so many articles in Mint but I really do not know what it means.
Jinny: Well, you might have heard about using a lever to lift weight by employing minimum force.
How does a lever work? If you have to budge a heavy stone, you simply use a long stick as a lever through a supporting point. If your lever is positioned correctly, you can budge even a heavy stone by using minimum force. So leveraging is all about putting the right force at the right position through a lever. In business and finance also, leverage seeks to achieve the same objective. It enables you to enhance your financial force by using the lever of borrowed money. In other words, the term leverage signifies the extent to which you are able to use borrowed money for your business. You have only Rs100 in your pocket but you are able to borrow Rs1,000 more from others. How are you able to do that?
Well, you show your Rs100 to Peter and ask him to lend you Rs100 more. Now you have Rs200 in your pocket, which you show to Paul to borrow Rs200 more. In this manner, you just keep on borrowing. Anyone who is able to borrow many times more than his own money is called highly leveraged.
Johnny: But I am not able to understand whether leverage is good, bad or ugly for the financial markets.
Jinny: Leverage gives you extra power. If you had only Rs100 in your pocket, without leverage, you would have ended using Rs100 only. Now you have extra cash, which you can use to increase your profit. But too much of anything is bad. Applying too much force on a stick to lift a heavy stone can sometimes break the stick. Similarly, too much of financial leverage can also put a company on the door of bankruptcy.
If your business is not able to generate enough profit, how are you going to pay back your lenders? So, leverage can work in both ways. It can increase your gains many times but it can also cause a heavy loss. Maintaining a proper balance between what you borrow and what you own is always necessary.
Johnny: That’s true. But tell me, how does leverage work in the case of derivative instruments?
Jinny: You can use derivative instruments for getting leverage in the financial markets. Let us try to understand this through an example. Suppose you have Rs1,000, which you want to invest for a month in the stock market. Suppose you want to purchase the stocks of a company, which is presently trading at a price of Rs10 per share in the spot market.
If you purchase the shares directly from the spot market, you can purchase only 100 shares. But take a look at another strategy. Instead of purchasing the shares from the spot market, you purchase one-month futures contracts of the same shares at the future price of, say, Rs12 per share.
For entering into a futures contract, you are not required to pay the whole future price of the shares. You only pay the initial margin money and marked-to-market margin on a day-to-day basis. Initial margin is what you pay upfront and marked-to-market margin is what you pay on the day-to-day value of your derivative contract.
If your broker is taking 10% as initial margin money, your Rs1,000 will fetch you shares worth Rs10,000. Even at a future price of, say, Rs12 per share, which is higher than the spot price, you would end up controlling more than 800 shares by following this strategy.
By using derivatives, you can earn a profit or suffer a loss, many times more than what you could have earned or lost by trading with the same amount of money in the spot market. This is how leverage through derivatives works.
Johnny: Thanks, Jinny, for telling me all this. I just remembered that I have invited some of my friends for lunch today. So, I will leave now. Bye.
What:The use of borrowed money for enhancing return on investment in business and finance is known as leverage. A company with more debt than equity is called highly leveraged.
Why: Leverage increases the potential for heavy profit but it also increases the potential for heavy loss.
Why not: Too much leverage can cause financial instability or even bankruptcy if the business is not able to generate enough profit.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org