We have looked at a variety of return measures. However, till now we assumed that the investment is made by the investor’s own money. However, in reality, the investor will not use only his money for making investments. The position will be leveraged. For example, while trading in futures contracts, the investor may have to put about 10% of the notional value as margin money. Even while buying stocks, the investor may invest part his money and part borrowed money.
When the investor invests 10% of the total required investment, then his profits and losses are amplified by 10 times. Similarly when he invests 50% of his money and 50% borrowed money, then the returns will double. In case of borrowed money, however, the investor may want to adjust his returns for the interest paid on the borrowed money.
In general, leverage increases the rate of return. The reason is mainly because a leveraged position is riskier compared to an unleveraged one. This is especially true while talking about the expected rate of return from an investment.
Let’s take an example. Let’s say an investment grows in value from $1000 to $1200.
If the entire $1000 was the investor’s money, then it’s an unleveraged position, and the investor’s returns would be:
R = (1200-1000)/1000 = 20%
However, if the investor had invested $500 of his money and the remaining $500 was borrowed money, then it’s a leveraged position. Assuming no interest cost, the return on the leveraged position would be:
R = (1200-1000)/500 = 40%
If there was an interest paid on the borrowed money, that would be deducted from the numerator while calculating the leveraged returns.