In finance, leverage, also known as gearing, involves using borrowed funds to purchase an investment with the aim of increasing the potential return on investment. By using debt, investors can amplify their purchasing power and potentially achieve higher rate of returns on invested equity.
Leverage can arise in various situations:
Instruments like options and futures are effectively leveraged bets where the principal is implicitly borrowed and lent at interest rates of very short treasury bills.
Business owners leverage their investment by having the business borrow a portion of its needed financing. The more it borrows, the less equity it needs, so any profits or losses are shared among a smaller base and are proportionately larger.
Businesses leverage their operations by using fixed cost inputs when revenues are expected to be variable. An increase in revenue will result in a larger increase in operating profit.
Hedge funds may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.