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

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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.

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

1

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:

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.

found above.

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.

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:

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.

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