The leverage magnifies the total size of gain or loss on an investment. It depends on the leverage size and the gap between leverage amount and total investment. It can be well explained through an example.
A bank either borrows money from the depositors or the shareholders purchase assets of the banks and source the funds. Considering that the bank borrows from depositors at a 0% interest rate, the bank will need to return the exact amount borrowed.
Suppose a bank invests $500, out of which $400 are borrowed, and $100 are sourced from the shareholder’s purchase of bank assets and stocks. If things turn out to be fruitful, the investment will yield a profit of 20%. If things go wrong, the investment will face a loss of 10%.
Thus, the investment will yield $600 in case of profit which will be precise enough to pay off the loan and will give a return of 100% on the bank’s own money, that is, $100 from shareholders’ purchase of assets. In vice-versa situations, the bank will earn only $450, enough to pay off the loan, with a total loss of $50 on its own money. The bank will face a loss of 50% on its investment sourced from the shareholders.
However, if the bank had borrowed $470, the bank’s profit after repaying the loan, in all favorable situations, would be 333.33%. On the contrary, a loss of $50 will not be sufficient to pay off the loan. The bank will lose 100% of its investment ($30) and will be in debt for $20.
Hence, the leverage size has magnified an investment’s total gain and loss.
