Financial risk management involves first determining the risk exposure of an investment or portfolio, and this is explored using leverage, duration, modified duration, convexity, effective duration, and effective convexity. I will highlight all of these aspects in this 5-part series.
The level of debt held, known as leverage, is a key factor affecting the risk exposure of an investor. Greater debt levels increase risk exposure as debt involves interest payments to the creditors who issued it, which must be paid before other commitments can be funded, and if interest rates change then greater repayments may be owed by an investor. This type of risk is known as interest rate risk, and an investor may be able to avoid it on a fixed repayment plan for small amounts of debt, but for large amounts of debt such as with mortgages the repayment costs will depend on the level of interest rates.
An investor’s balance sheet can be examined to calculate their leverage, and leverage is the ratio of all liabilities to non-debt liabilities (i.e. shareholders’ equity). It can be found by dividing the total value of all liabilities by the total value of all non-debt liabilities:
Leverage = Total liabilities / Non-debt liabilities
Leverage = Total liabilities / Shareholders’ equity
If an investor has no debt at all then debt liability value will be zero, and non-debt liability value = total liability value. This simplifies the equation to that below:
An investor without debt
Leverage = Total liabilities / Non-debt liabilities
Leverage = Total liabilities / Total liabilities
Leverage = 1
The case of an investor without debt or interest rate risk, with a leverage level of 1, is used as a basis to evaluate situations where an investor does have debt and risk exposure to interest rate risk. The higher the leverage factor moves above 1 the greater the risk factor an investor will face.
For example, an investor’s total liabilities may come to £100 million, of which £80 million may relate to shareholder’s equity and £20 million to mortgage debt obligations. In this example, the investor’s leverage is 1.25:
An investor with debt
Leverage = Total liabilities / Non-debt liabilities
Leverage = Total liabilities / Shareholders’ equity
Leverage = £100 million / £80 million
Leverage = 1.25
Alternatively, an investor may hold liabilities to the total value of £900,000, with £400,000 as mortgage costs, and £500,000 as investor’s equity. If shares are not publicly distributed to shareholders (i.e. with a private firm) then shareholders’ equity equals investor’s equity, and here this gives a leverage factor of 1.8:
Leverage = Total liabilities / Non-debt liabilities
Leverage = Total liabilities / Shareholders’ equity
Leverage = £900,000 / £500,000
Leverage = 1.8
There is no such thing as leverage that is too high or too low, and it all depends on the firm’s preferences. Greater debt and leverage will increase an investor’s interest rate risk, and see interest rate changes cause larger changes to the level of interest payments they must pay on their debt and to portfolio value, but this can work both ways. Increased interest rate risk is a bad thing if interest rates go in an unwanted direction and reduce the value of portfolio securities, but a good thing if interest rates go in the desired direction and raise the value of portfolio securities.
Do check related posts:
- Debt and Leverage
- Duration
- Modified Duration & Risk Sensitivity
- Convexity
- Effective Duration & Effective Convexity