Leverage: Good, Bad, or Just Plain Ugly?

Structurers are often asked to generates strategies that can outperform the forward. Adding leverage is often the easiest way of achieving this outcome.

This presentation explores how leverage can be added in several ways.

Strategy	Leverage	Example
Ratios	On each fixing	1x2 type structures where the obligation amount is double the protected amount. E.g., strip of monthly $5m x $10m leveraged forwards for the next 12-months
Extensions	At the back-end	A 12- into 24-month strategy where the first 12-months are guaranteed (part one), and months 13-24 (part two) are subject to the extension event taking effect at month 12
Callable	At the back-end	A 24-month strategy that can be cancelled (called) after (e.g.,) month 12. This replicates the Extension strategy, but is presented as a long-dated strategy at the outset that is shortened; rather than a shorter strategy that potential extends into a longer period
Correlation	On each fixing	This can be where value is generated by scaling the notional amount to the performance of other asset classes (e.g., commodities / equities) or currency pairs (e.g., dual strategies)

Adding leverage does not come without its risks. For example:

The Good… When leverage works it enables users to generate value. That value can be used to capture immediate rate enhancement or fund the unwind of unattractive legacy trades. This may be viewed as good risk management.

The Bad… However, leverage can also be viewed as bad. For example, when used inappropriately it can lead to over-hedged positions and financial loss.

The Ugly… When used excessively, leverage may be described as “damn right ugly.” Many of the mis-selling scandals around derivatives have resulted from the over-use of leverage (e.g., TARFs).

20241011 - EAKO - Leverage - Good or Bad.pdf

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