Hedge Funds

[Chaapa]

What does it mean for hedge funds to be highly leveraged?

Could someone please give an example.

Thanks in advance.

 

[GraemeC]

My understanding is:

If a fund has shareholder equity of 100 and also borrows 100 it has 200 to invest.

If it earns a 10% return on the 200, it receives 20. If it then pays interest of 5 on its borrowings it is left with 15 for its shareholders - a return of 15% on the 100 of equity.

Repeat the calculation with 900 of borrowings and 100 of equity and you get 55% return on the equity after paying 45 of interest.

If, instead, it earns -10% on 1000 then its shareholders are wiped out and there isn't enough to pay the interest on the borrowings.

What does it mean for hedge funds to be highly leveraged?

Could someone please give an example.

Thanks in advance.

 

[Chaapa]

Thank you very much for your help. Its alot clear to me now.

My understanding is:

If a fund has shareholder equity of 100 and also borrows 100 it has 200 to invest.

If it earns a 10% return on the 200, it receives 20. If it then pays interest of 5 on its borrowings it is left with 15 for its shareholders - a return of 15% on the 100 of equity.

Repeat the calculation with 900 of borrowings and 100 of equity and you get 55% return on the equity after paying 45 of interest.

If, instead, it earns -10% on 1000 then its shareholders are wiped out and there isn't enough to pay the interest on the borrowings.

 

[Ankmola]

In addition to the overt leverage i.e. borrowing, hedge funds take derivative positions which result in leverage e.g. delta in an option, margin in a future.

Employing derivative positions will increase a hedge fund's leverage i.e. large losses or large gains possible per unit of commitment.

It is also well known that hedge funds are less regulated than unit trusts/ mutual funds. And so brave derivative positions are the norm!