Hedge Funds, Financial Stability and Market Integrity Appendix 2: Leverage and Financial Markets

Investors taking positions in financial markets can obtain leverage in a number of ways. One option is to borrow directly from an institution (or to issue debt securities) and then purchase financial instruments. A second, and more frequently used, option is to undertake market transactions in financial instruments. There are three general ways in which this can be done: transactions in the foreign exchange market, undertaking repos, and the purchase and sale of derivatives (such as options).^[1]

The nature of margining requirements and the ability of investors to obtain trading lines are important determinants of the amount of leverage that investors are able to obtain. To illustrate this, we use a transaction that has been commonly employed by hedge funds to short the Australian dollar (AUD).

Suppose the current AUD/USD exchange rate is US68 cents for one AUD, US interest rates are 4.5 per cent, Australian rates are 5.5 per cent, and an investor expects the AUD to depreciate significantly over the next week and so wishes to establish a short position of AUD10 million. The most frequently used method of establishing this speculative position involves two steps:

Step 1: Selling AUD10 million spot and buying USD6.8 million (for delivery in 2 days time).

Step 2: Undertaking a foreign currency swap in which AUD10 million is purchased spot for USD6.8 million (for delivery in 2 days time) and then sold for USD6.7988 million in 7 days time.

The combined effect of these transactions is that the investor has established a short position in AUD without the need for any capital or liquidity up front – the AUD funds that are needed to settle the spot transaction are obtained through the first leg of the swap.

The ability of an investor to take on much larger positions of this type is partly constrained by its ability to obtain trading lines. Financial institutions place limits on the face value of contracts that they are prepared to deal with a single investor or counterparty. These limits are related, amongst other things, to the counterparty's capital and the nature of its business. Over recent years, however, some global financial institutions faced with strong competitive pressures have been prepared to grant extremely generous lines to hedge funds, often in ignorance of the extent of similar lines from other institutions, and in excess of what normal risk management practices would suggest. This has allowed the hedge funds to obtain very large positions.

Another possible constraint on leverage is the need for a margin to be posted when a position is established. In practice, as in the above example, such margins are typically not required in the foreign exchange market. An additional constraint might apply if financial institutions require mark-to-market exposures to be collateralised (through the equivalent of a margin call). For example, using the above transaction, if after 4 days the AUD rate had appreciated to 0.70 (contrary to the hedge fund's expectation), the bank might require the hedge fund to provide AUD0.3 million in cash or government securities to cover its credit exposure. While such margining practices have become more common over recent years, they are not universally used.

In contrast to the foreign exchange market, when positions are established in securities markets a margin is typically required up-front. These positions are usually created and funded through a repurchase agreement which is a form of over-collateralised loan. The lender effectively takes a margin, or ‘haircut’, by requiring collateral that exceeds the value of the loan. This haircut is designed to protect the lender against adverse movements in the price of the collateral. In government securities markets in most industrial countries, haircuts usually run at 2 per cent of the value of the loan, although they can vary with the maturity of the security. Thus, a hedge fund that had $2 billion in capital could, through repos, borrow enough to fund a holding of $100 billion of securities by applying the capital to haircuts – that is, it could gear up 50 times.

The haircuts involved on repos in emerging market securities are larger than those on Treasury securities but still allow substantial gearing. Because these markets had performed well over a run of years, and their price volatility had declined, haircuts had been below levels which could absorb recent falls in values.

Up-front margins also need to be paid on other derivatives contracts. Initial margins are typically less than 2 per cent for bond contracts and less than 6 per cent for equity contracts, allowing investors to take on exposures to market positions that are many multiples of their capital. With options, the extent of gearing that can be attained depends on the premia that investors need to pay, which vary with market conditions and the characteristics of the options. In most cases, however, the premium is only a small percentage of the face value of the option, so that once again very high gearing can be attained.

Footnote

Garber (1998) provides a useful summary of various ways in which transactions in financial markets can be used to gain leverage and disguise capital flows. [1]