Showing posts with label finance. Show all posts
Showing posts with label finance. Show all posts

Wednesday, 30 August 2017

Finance


Blogger Ref  http://www.p2pfoundation.net/Transfinancial_Economics




Finance is a field that deals with the study of investments. It includes the dynamics of assets and liabilities over time under conditions of different degrees of uncertainty and risk. Finance can also be defined as the science of money management. Finance aims to price assets based on their risk level and their expected rate of return. Finance can be broken into three different sub-categories: public finance, corporate finance and personal finance.


Areas of finance[edit]

Personal finance[edit]

Main article: Personal finance
Questions in personal finance revolve around:
  • Protection against unforeseen personal events, as well as events in the wider economies
  • Transference of family wealth across generations (bequests and inheritance)
  • Effects of tax policies (tax subsidies or penalties) management of personal finances
  • Effects of credit on individual financial standing
  • Development of a savings plan or financing for large purchases (auto, education, home)
  • Planning a secure financial future in an environment of economic instability
Warren Buffett is an American investor, business magnate, and philanthropist. He is considered by some to be one of the most successful investors in the world.
Personal finance may involve paying for education, financing durable goods such as real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal finance may also involve paying for a loan, or debt obligations. The six key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are:[1]
  1. Financial position: is concerned with understanding the personal resources available by examining net worth and household cash flow. Net worth is a person's balance sheet, calculated by adding up all assets under that person's control, minus all liabilities of the household, at one point in time. Household cash flow totals up all the expected sources of income within a year, minus all expected expenses within the same year. From this analysis, the financial planner can determine to what degree and in what time the personal goals can be accomplished.
  2. Adequate protection: the analysis of how to protect a household from unforeseen risks. These risks can be divided into the following: liability, property, death, disability, health and long term care. Some of these risks may be self-insurable, while most will require the purchase of an insurance contract. Determining how much insurance to get, at the most cost effective terms requires knowledge of the market for personal insurance. Business owners, professionals, athletes and entertainers require specialized insurance professionals to adequately protect themselves. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a critical piece of the overall investment planning.
  3. Tax planning: typically the income tax is the single largest expense in a household. Managing taxes is not a question of if you will pay taxes, but when and how much. Government gives many incentives in the form of tax deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically, as one's income grows, a higher marginal rate of tax must be paid. Understanding how to take advantage of the myriad tax breaks when planning one's personal finances can make a significant impact in which it can later save you money in the long term.
  4. Investment and accumulation goals: planning how to accumulate enough money – for large purchases and life events – is what most people consider to be financial planning. Major reasons to accumulate assets include, purchasing a house or car, starting a business, paying for education expenses, and saving for retirement. Achieving these goals requires projecting what they will cost, and when you need to withdraw funds that will be necessary to be able to achieve these goals. A major risk to the household in achieving their accumulation goal is the rate of price increases over time, or inflation. Using net present value calculators, the financial planner will suggest a combination of asset earmarking and regular savings to be invested in a variety of investments. In order to overcome the rate of inflation, the investment portfolio has to get a higher rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio risks is most often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation to be invested in stocks (either preferred stock or common stock), bonds (for example mutual bonds or government bonds, or corporate bonds), cash and alternative investments. The allocation should also take into consideration the personal risk profile of every investor, since risk attitudes vary from person to person.
  5. Retirement planning is the process of understanding how much it costs to live at retirement, and coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement plan include taking advantage of government allowed structures to manage tax liability including: individual (IRA) structures, or employer sponsored retirement plans.
  6. Estate planning involves planning for the disposition of one's assets after death. Typically, there is a tax due to the state or federal government at one's death. Avoiding these taxes means that more of one's assets will be distributed to one's heirs. One can leave one's assets to family, friends or charitable groups.

Corporate finance[edit]

Main article: Corporate finance
Jack Welch an American retired business executive, author, and chemical engineer. He was chairman and CEO of General Electric between 1981 and 2001. During his tenure at GE, the company's value rose 4,000%.
Corporate finance deals with the sources funding and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. Corporate finance generally involves balancing risk and profitability, while attempting to maximize an entity's assets, net incoming cash flow and the value of its stock, and generically entails three primary areas of capital resource allocation. In the first, "capital budgeting", management must choose which "projects" (if any) to undertake. The discipline of capital budgeting may employ standard business valuation techniques or even extend to real options valuation; see Financial modeling. The second, "sources of capital" relates to how these investments are to be funded: investment capital can be provided through different sources, such as by shareholders, in the form of equity (privately or via an initial public offering), creditors, often in the form of bonds, and the firm's operations (cash flow). Short-term funding or working capital is mostly provided by banks extending a line of credit. The balance between these elements forms the company's capital structure. The third, "the dividend policy", requires management to determine whether any unappropriated profit (excess cash) is to be retained for future investment / operational requirements, or instead to be distributed to shareholders, and if so, in what form. Short term financial management is often termed "working capital management", and relates to cash-, inventory- and debtors management.
Corporate finance also includes within its scope business valuation, stock investing, or investment management. An investment is an acquisition of an asset in the hope that it will maintain or increase its value over time that will in hope give back a higher rate of return when it comes to disbursing dividends. In investment management – in choosing a portfolio – one has to use financial analysis to determine what, how much and when to invest. To do this, a company must:
  • Identify relevant objectives and constraints: institution or individual goals, time horizon, risk aversion and tax considerations;
  • Identify the appropriate strategy: active versus passive hedging strategy
  • Measure the portfolio performance
James Harris Simons American mathematician, hedge fund manager, and philanthropist. He is known as a quantitative investor and in 1982 founded Renaissance Technologies, a private hedge fund based in New York City.
Financial management overlaps with the financial function of the accounting profession. However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm's value to the shareholders and increase their rate of return on the investments.
Financial risk management, an element of corporate finance, is the practice of creating and protecting economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. (Other risk types include foreign exchange, shape, volatility, sector, liquidity, inflation risks, etc.) It focuses on when and how to hedge using financial instruments; in this sense it overlaps with financial engineering. Similar to general risk management, financial risk management requires identifying its sources, measuring it (see: Risk measure: Well known risk measures), and formulating plans to address these, and can be qualitative and quantitative. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.[citation needed]

Financial services[edit]

Main article: Financial services
An entity whose income exceeds its expenditure can lend or invest the excess income to help that excess income produce more income in the future. Though on the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income. The lender can find a borrower—a financial intermediary such as a bank—or buy notes or bonds (corporate bonds, government bonds, or mutual bonds) in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary earns the difference for arranging the loan.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes, to coordinate their activity.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate finance) and by a wide variety of other organizations such as schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments and methodologies, with consideration to their institutional setting.
Finance is one of the most important aspects of business management and includes analysis related to the use and acquisition of funds for the enterprise.
In corporate finance, a company's capital structure is the total mix of financing methods it uses to raise funds. One method is debt financing, which includes bank loans and bond sales. Another method is equity financing – the sale of stock by a company to investors, the original shareholders (they own a portion of the business) of a share. Ownership of a share gives the shareholder certain contractual rights and powers, which typically include the right to receive declared dividends and to vote the proxy on important matters (e.g., board elections). The owners of both bonds (either government bonds or corporate bonds) and stock (whether its preferred stock or common stock), may be institutional investors – financial institutions such as investment banks and pension funds  or private individuals, called private investors or retail investors.

Public finance[edit]

Main article: Public finance
Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties, municipalities, etc.) and related public entities (e.g. school districts) or agencies. It usually encompasses a long-term, strategic perspective regarding investment decisions that affect public entities.[2] These long-term, strategic periods usually encompass five or more years.[3] Public finance is primarily concerned with:
  • Identification of required expenditure of a public sector entity
  • Source(s) of that entity's revenue
  • The budgeting process
  • Debt issuance (municipal bonds) for public works projects
Central banks, such as the Federal Reserve System banks in the United States and Bank of England in the United Kingdom, are strong players in public finance, acting as lenders of last resort as well as strong influences on monetary and credit conditions in the economy.[4]

Capital[edit]

Main article: Financial capital
Capital, in the financial sense, is the money that gives the business the power to buy goods to be used in the production of other goods or the offering of a service. (The capital has two types of resources, Equity and Debt).
The deployment of capital is decided by the budget. This may include the objective of business, targets set, and results in financial terms, e.g., the target set for sale, resulting cost, growth, required investment to achieve the planned sales, and financing source for the investment.
A budget may be long term or short term. Long term budgets have a time horizon of 5–10 years giving a vision to the company; short term is an annual budget which is drawn to control and operate in that particular year.
Budgets will include proposed fixed asset requirements and how these expenditures will be financed. Capital budgets are often adjusted annually (done every year) and should be part of a longer-term Capital Improvements Plan.
A cash budget is also required. The working capital requirements of a business are monitored at all times to ensure that there are sufficient funds available to meet short-term expenses.
The cash budget is basically a detailed plan that shows all expected sources and uses of cash when it comes to spending it appropriately. The cash budget has the following six main sections:
  1. Beginning Cash Balance – contains the last period's closing cash balance, in other words, the remaining cash from last years earnings.
  2. Cash collections – includes all expected cash receipts (all sources of cash for the period considered, mainly sales)
  3. Cash disbursements – lists all planned cash outflows for the period such as dividend, excluding interest payments on short-term loans, which appear in the financing section. All expenses that do not affect cash flow are excluded from this list (e.g. depreciation, amortization, etc.)
  4. Cash excess or deficiency – a function of the cash needs and cash available. Cash needs are determined by the total cash disbursements plus the minimum cash balance required by company policy. If total cash available is less than cash needs, a deficiency exists.
  5. Financing – discloses the planned borrowings and repayments of those planned borrowings, including interest.

Financial theory[edit]

Financial economics[edit]

Main article: Financial economics
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to goods and services. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It centres on managing risk in the context of the financial markets, and the resultant economic and financial models. It essentially explores how rational investors would apply risk and return to the problem of an investment policy. Here, the twin assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black–Scholes theory for option valuation; it further studies phenomena and models where these assumptions do not hold, or are extended. "Financial economics", at least formally, also considers investment under "certainty" (Fisher separation theorem, "theory of investment value", Modigliani–Miller theorem) and hence also contributes to corporate finance theory. Financial econometrics is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.
Although closely related, the disciplines of economics and finance are distinctive. The “economy” is a social institution that organizes a society’s production, distribution, and consumption of goods and services, all of which must be financed.
Economists make a number of abstract assumptions for purposes of their analyses and predictions. They generally regard financial markets that function for the financial system as an efficient mechanism (Efficient-market hypothesis). Instead, financial markets are subject to human error and emotion.[5] New research discloses the mischaracterization of investment safety and measures of financial products and markets so complex that their effects, especially under conditions of uncertainty, are impossible to predict. The study of finance is subsumed under economics as financial economics, but the scope, speed, power relations and practices of the financial system can uplift or cripple whole economies and the well-being of households, businesses and governing bodies within them—sometimes in a single day.

Financial mathematics[edit]

Main article: Financial mathematics
Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory that is involved in financial mathematics. Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known as financial engineering). Arguably, these are largely synonymous, although the latter focuses on application, while the former focuses on modelling and derivation (see: Quantitative analyst). The field is largely focused on the modelling of derivatives, although other important subfields include insurance mathematics and quantitative portfolio problems. See Outline of finance: Mathematical tools; Outline of finance: Derivatives pricing.

Experimental finance[edit]

Main article: Experimental finance
Experimental finance aims to establish different market settings and environments to observe experimentally and provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanisms, and returns processes. Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions and therefore prove them, and attempt to discover new principles on which such theory can be extended and be applied to future financial decisions. Research may proceed by conducting trading simulations or by establishing and studying the behavior, and the way that these people act or react, of people in artificial competitive market-like settings.

Behavioral finance[edit]

Main article: Behavioral economics
Behavioral finance studies how the psychology of investors or managers affects financial decisions and markets when making a decision that can impact either negatively or positively on one of their areas. Behavioral finance has grown over the last few decades to become central and very important to finance.[6]
Behavioral finance includes such topics as:
  1. Empirical studies that demonstrate significant deviations from classical theories.
  2. Models of how psychology affects and impacts trading and prices
  3. Forecasting based on these methods.
  4. Studies of experimental asset markets and use of models to forecast experiments.
A strand of behavioral finance has been dubbed Quantitative Behavioral Finance, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. Some of these endeavors has been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm and others have demonstrated significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.

Professional qualifications[edit]

There are several related professional qualifications, that can lead to the field:

Unsolved problems in finance[edit]

As the debate to whether finance is an art or a science is still open,[7] there have been recent efforts to organize a list of unsolved problems in finance.

See also[edit]

References[edit]

  1. Jump up ^ "Financial Planning Curriculum Framework". Financial Planning Standards Board. 2011. Archived from the original on 1 February 2012. Retrieved 7 April 2012. 
  2. Jump up ^ Doss, Daniel; Sumrall, William; Jones, Don (2012). Strategic Finance for Criminal Justice Organizations (1st ed.). Boca Raton, Florida: CRC Press. p. 23. ISBN 978-1439892237. 
  3. Jump up ^ Doss, Daniel; Sumrall, William; Jones, Don (2012). Strategic Finance for Criminal Justice Organizations (1st ed.). Boca Raton, Florida: CRC Press. pp. 53–54. ISBN 978-1439892237. 
  4. Jump up ^ Board of Governors of Federal Reserve System of the United States. Mission of the Federal Reserve System. Federalreserve.gov Accessed: 2010-01-16. (Archived by WebCite at Archived 2010-01-16 at WebCite)
  5. Jump up ^ Berezin, M. (2005). "Emotions and the Economy" in Smelser, N.J. and R. Swedberg (eds.) The Handbook of Economic Sociology, Second Edition. Princeton University Press: Princeton, NJ
  6. Jump up ^ Shefrin, Hersh (2002). Beyond greed and fear: Understanding behavioral finance and the psychology of investing. New York, NY: Oxford University Press. p. ix. ISBN 978-0195304213. Retrieved 8 May 2017. 
  7. Jump up ^ "Is finance an art or a science?". Investopedia. Retrieved 2015-11-11. 

External links[edit]

Retrieved from "https://en.wikipedia.org/w/index.php?title=Finance&oldid=797717803"
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Tuesday, 16 June 2015

Leverage (finance) ...or Creating Money Out of Thin Air..........



I thought it would be "fun" to see what Wikipedia says on bank leverage, or creating new money ex nihilo which is supposed to be based on the amount of existing money.....


Blogger Ref http://www.p2pfoundation.net/Transfinancial_Economics


 
From Wikipedia, the free encyclopedia
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In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is any technique to multiply gains and losses.[1] Most often it involves buying more of an asset by using borrowed funds, with the belief that the income from the asset or asset price appreciation will be more than the cost of borrowing. Almost always this involves the risk that borrowing costs will be larger than the income from the asset or the value of the asset will fall, leading to incurred losses.


Source[edit]

  • Individuals leverage their savings when buying a home by financing a portion of the purchase price with mortgage debt.
  • Individuals leverage their exposure to financial investments by borrowing from their broker.
  • Securities like options and futures contracts are bets between parties where the principal is implicitly borrowed/lent at very short T-bill rates.[2]
  • Equity owners of businesses 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 as a result.[3]
  • 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 income.[4][5]
  • Hedge funds may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.

Risk[edit]

While leverage magnifies profits when the returns from the asset more than offset the costs of borrowing, losses are magnified when the opposite is true. A corporation that borrows too much money might face bankruptcy or default during a business downturn, while a less-leveraged corporation might survive. An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%.[6]
Risk may be attributed to a loss in value of collateral assets. Brokers may require the addition of funds when the value of securities hold declines. Banks may fail to renew mortgages when the value of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to maintain the ongoing borrowing costs, loans may be called.
This may happen exactly when there is little market liquidity and sales by others are depressing prices. It means that as things get bad, leverage goes up, multiplying losses as things continue to go down. This can lead to rapid ruin, even if the underlying asset value decline is mild or temporary.[6] The risk can be mitigated by negotiating the terms of leverage, by maintaining unused room for additional borrowing, and by leveraging only liquid assets.[7]
On the other hand, the extreme level of leverage afforded in forex trading presents relatively low risk per unit due to its relative stability when compared with other markets. Compared with other trading markets, forex traders must trade a much higher volume of units in order to make any considerable profit. For example, many brokers offer 100:1 leverage for investors, meaning that someone bringing $1,000 can control $100,000 while taking responsibility for any losses or gains their investments incur. This intense level of leverage presents equal parts risk and reward.
There is an implicit assumption in that account, however, which is that the underlying levered asset is the same as the unlevered one. If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diversification might more than offset the additional risk from leverage.[6] Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, with a limited downside.[7] Or if both long and short positions are held by a pairs-trading stock strategy the matching and off-setting economic leverage may lower overall risk levels.
So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly levered hedge funds have less return volatility than unlevered bond funds,[7] and public utilities with lots of debt are usually less risky stocks than unlevered technology companies.[6]

Measuring[edit]

A good deal of confusion arises in discussions among people who use different definitions of leverage. The term is used differently in investments and corporate finance, and has multiple definitions in each field.[8]

Investments[edit]

Accounting leverage is total assets divided by the total assets minus total liabilities.[9] Notional leverage is total notional amount of assets plus total notional amount of liabilities divided by equity.[1] Economic leverage is volatility of equity divided by volatility of an unlevered investment in the same assets. To understand the differences, consider the following positions, all funded with $100 of cash equity:[6]
  • Buy $100 of crude oil with money out of pocket. Assets are $100 ($100 of oil), there are no liabilities, and assets minus liabilities equals owners' equity. Accounting leverage is 1 to 1. The notional amount is $100 ($100 of oil), there are no liabilities, and there is $100 of equity, so notional leverage is 1 to 1. The volatility of the equity is equal to the volatility of oil, since oil is the only asset and you own the same amount as your equity, so economic leverage is 1 to 1.
  • Borrow $100 and buy $200 of crude oil. Assets are $200, liabilities are $100 so accounting leverage is 2 to 1. The notional amount is $200 and equity is $100, so notional leverage is 2 to 1. The volatility of the position is twice the volatility of an unlevered position in the same assets, so economic leverage is 2 to 1.
  • Buy $100 of crude oil, borrow $100 worth of gasoline, and sell the gasoline for $100. The seller now has $100 cash and $100 of crude oil, and owes $100 worth of gasoline. Your assets are $200, and liabilities are $100, so accounting leverage is 2 to 1. You have $200 in notional assets plus $100 in notional liabilities, with $100 of equity, so your notional leverage is 3 to 1. The volatility of your position might be half the volatility of an unlevered investment in the same assets, since the price of oil and the price of gasoline are positively correlated, so your economic leverage might be 0.5 to 1.
  • Buy $100 of a 10-year fixed-rate treasury bond, and enter into a fixed-for-floating 10-year interest rate swap to convert the payments to floating rate. The derivative is off-balance sheet, so it is ignored for accounting leverage. Accounting leverage is therefore 1 to 1. The notional amount of the swap does count for notional leverage, so notional leverage is 2 to 1. The swap removes most of the economic risk of the treasury bond, so economic leverage is near zero.

Abbreviations[edit]

Corporate finance[edit]

\mathrm{DOL} = \frac{\mathrm{EBIT\;+\;Fixed\;Costs}}{\mathrm{EBIT}}
\mathrm{DFL} = \frac{\mathrm{EBIT}}{\mathrm{EBIT\;-\;Total\;Interest\;Expense}}
\mathrm{DCL} = \mathrm{DOL * DFL} = \frac{\mathrm{EBIT\;+\;Fixed\;Costs}}{\mathrm{EBIT\;-\;Total\;Interest\;Expense}}
Accounting leverage has the same definition as in investments.[10] There are several ways to define operating leverage, the most common.[11] is:
\mathrm{Operating\;leverage} = \frac{\mathrm{Revenue} - \mathrm{Variable\;Cost}}{\mathrm{Revenue} - \mathrm{Variable\;Cost} - \mathrm{Fixed\;Cost}} = \frac{\mathrm{Revenue} - \mathrm{Variable\;Cost}}{\mathrm{Operating\;Income}}
Financial leverage is usually defined[9][12] as:
\mathrm{Financial\;leverage}= \frac{\mathrm{Total\;Debt}}{\mathrm{Shareholders'\;Equity}}

For outsiders, it is hard to calculate operating leverage as fixed and variable costs are usually not disclosed. In an attempt to estimate operating leverage, one can use the percentage change in operating income for a one-percent change in revenue.[13] The product of the two is called Total leverage,[14] and estimates the percentage change in net income for a one-percent change in revenue.[15]
There are several variants of each of these definitions,[16] and the financial statements are usually adjusted before the values are computed.[9] Moreover, there are industry-specific conventions that differ somewhat from the treatment above.[17]

Bank regulation[edit]

After the 1980s, quantitative limits on bank leverage were rare. Banks in most countries had a reserve requirement, a fraction of deposits that was required to be held in liquid form, generally precious metals or government notes or deposits. This does not limit leverage. A capital requirement is a fraction of assets that is required to be funded in the form of equity or equity-like securities. Although these two are often confused, they are in fact opposite. A reserve requirement is a fraction of certain liabilities (from the right hand side of the balance sheet) that must be held as a certain kind of asset (from the left hand side of the balance sheet). A capital requirement is a fraction of assets (from the left hand side of the balance sheet) that must be held as a certain kind of liability or equity (from the right hand side of the balance sheet). Before the 1980s, regulators typically imposed judgmental capital requirements, a bank was supposed to be "adequately capitalized," but not objective rules.[18]
National regulators began imposing formal capital requirements in the 1980s, and by 1988 most large multinational banks were held to the Basel I standard. Basel I categorized assets into five risk buckets, and mandated minimum capital requirements for each. This limits accounting leverage. If a bank is required to hold 8% capital against an asset, that is the same as an accounting leverage limit of 1/.08 or 12.5 to 1.[19]
While Basel I is generally credited with improving bank risk management it suffered from two main defects. It did not require capital for all off-balance sheet risks (there was a clumsy provisions for derivatives, but not for certain other off-balance sheet exposures) and it encouraged banks to pick the riskiest assets in each bucket (for example, the capital requirement was the same for all corporate loans, whether to solid companies or ones near bankruptcy, and the requirement for government loans was zero).[18]
Work on Basel II began in the early 1990s and it was implemented in stages beginning in 2005. Basel II attempted to limit economic leverage rather than accounting leverage. It required advanced banks to estimate the risk of their positions and allocate capital accordingly. While this is much more rational in theory, it is more subject to estimation error, both honest and opportunitistic.[19] The poor performance of many banks during the financial crisis of 2007–2009 led to calls to reimpose leverage limits, by which most people meant accounting leverage limits, if they understood the distinction at all. However, in view of the problems with Basel I, it seems likely that some hybrid of accounting and notional leverage will be used, and the leverage limits will be imposed in addition to, not instead of, Basel II economic leverage limits.[20]

Financial crisis of 2007–2009[edit]

The financial crisis of 2007–2009, like many previous financial crises, was blamed in part on "excessive leverage".
  • Consumers in the United States and many other developed countries had high levels of debt relative to their wages, and relative to the value of collateral assets. When home prices fell, and debt interest rates reset higher, and business laid off employees, borrowers could no longer afford debt payments, and lenders could not recover their principal by selling collateral.
  • Financial institutions were highly levered. Lehman Brothers, for example, in its last annual financial statements, showed accounting leverage of 30.7 times ($691 billion in assets divided by $22 billion in stockholders’ equity).[21] Bankruptcy examiner Anton R. Valukas determined that the true accounting leverage was higher: it had been understated due to dubious accounting treatments including the so-called repo 105 (allowed by Ernst & Young).[22]
  • Banks' notional leverage was more than twice as high, due to off-balance sheet transactions. At the end of 2007, Lehman had $738 billion of notional derivatives in addition to the assets above, plus significant off-balance sheet exposures to special purpose entities, structured investment vehicles and conduits, plus various lending commitments, contractual payments and contingent obligations.[21]
  • On the other hand, almost half of Lehman’s balance sheet consisted of closely offsetting positions and very-low-risk assets, such as regulatory deposits. The company emphasized "net leverage", which excluded these assets. On that basis, Lehman held $373 billion of "net assets" and a "net leverage ratio" of 16.1.[21] This is not a standardized computation, but it probably corresponds more closely to what most people think of when they hear of a leverage ratio.[citation needed]

Use of language[edit]

Levering has come to be known as "leveraging", in financial communities; this may have originally been a slang adaptation, since leverage was a noun. However, modern dictionaries (such as Random House Dictionary and Merriam-Webster's Dictionary of Law[23]) refer to its use as a verb, as well.[24] It was first adopted for use as a verb in American English in 1957.[25]

See also[edit]

References[edit]

  1. ^ Jump up to: a b Brigham, Eugene F., Fundamentals of Financial Management (1995).
  2. Jump up ^ Mock, E. J., R. E. Schultz, R. G. Schultz, and D. H. Shuckett, Basic Financial Management (1968).
  3. Jump up ^ Grunewald, Adolph E. and Erwin E. Nemmers, Basic Managerial Finance (1970).
  4. Jump up ^ Ghosh, Dilip K. and Robert G. Sherman (June 1993). "Leverage, Resource Allocation and Growth". Journal of Business Finance & Accounting. pp. 575–582. 
  5. Jump up ^ Lang, Larry, Eli Ofek, and Rene M. Stulz (January 1996). "Leverage, Investment, and Firm Growth". Journal of Financial Economics. pp. 3–29. 
  6. ^ Jump up to: a b c d e Bodie, Zvi, Alex Kane and Alan J. Marcus, Investments, McGraw-Hill/Irwin (June 18, 2008)
  7. ^ Jump up to: a b c Chew, Lillian (July 1996). Managing Derivative Risks: The Use and Abuse of Leverage. John Wiley & Sons. 
  8. Jump up ^ Van Horne (1971). Financial Management and Policy. 
  9. ^ Jump up to: a b c Weston, J. Fred and Eugene F. Brigham, Managerial Finance (1969).
  10. Jump up ^ Weston, J. Fred and Eugene F. Brigham, Managerial Finance (2010).
  11. Jump up ^ Brigham, Eugene F., Fundamentals of Financial Management (1995)
  12. Jump up ^ "Financial Leverage". Retrieved 16 December 2012. 
  13. Jump up ^ Damodaran (2011), Applied Corporate Finance, 3rd ed., pp. 132-133>
  14. Jump up ^ Li, Rong-Jen and Glenn V. Henderson, Jr., "Combined Leverage and Stock Risk," Quarterly Journal of Business & Finance (Winter 1991), p. 18-39.
  15. Jump up ^ Huffman, Stephen P., "The Impact of Degrees of Operating and Financial Leverage on the Systematic Risk of Common Stock: Another Look," Quarterly Journal of Business & Economics (Winter 1989), p. 83-100.
  16. Jump up ^ Dugan, Michael T., Donald Minyard, and Keith A. Shriver, "A Re-examination of the Operating Leverage-Financial Leverage Tradeoff," Quarterly Review of Economics & Finance (Fall 1994), p. 327-334.
  17. Jump up ^ Darrat, Ali F.d and Tarun K. Mukherjee, "Inter-Industry Differences and the Impact of Operating and Financial Leverages on Equity Risk," Review of Financial Economics (Spring 1995), p. 141–155.
  18. ^ Jump up to: a b Ong, Michael K., The Basel Handbook: A Guide for Financial Practitioners, Risk Books (December 2003)
  19. ^ Jump up to: a b Saita, Francesco, Value at Risk and Bank Capital Management: Risk Adjusted Performances, Capital Management and Capital Allocation Decision Making, Academic Press (February 3, 2007)
  20. Jump up ^ Tarullo, Daniel K., Banking on Basel: The Future of International Financial Regulation, Peterson Institute for International Economics (September 30, 2008)
  21. ^ Jump up to: a b c Lehman Brothers Holdings Inc Annual Report for year ended November 30, 2007 http://www.sec.gov/Archives/edgar/data/806085/000110465908005476/a08-3530_110k.htm#Item6_SelectedFinancialData_003911.
  22. Jump up ^ Report of Anton R. Valukas, Examiner, to the United States Bankruptcy Court, Southern District of New York, Chapter 11 Case No. 08-13555 (JMP).
  23. Jump up ^ Merrian-Webster's Dictionary of Law. Merriam-Webster. June 2011 (Original edition). ISBN 978-0877797197.  Check date values in: |date= (help)
  24. Jump up ^ "leverage." Merriam-Webster's Dictionary of Law. Merriam-Webster, Inc. 7 June 2011. Dictionary.com
  25. Jump up ^ "leverage." Online Etymology Dictionary. Douglas Harper, Historian. 7 June 2011. Dictionary.com

Further reading[edit]

  1. Bartram, Söhnke M.; Brown, Gregory W.; Waller, William (August 2013). "How Important is Financial Risk?". Journal of Financial and Quantitative Analysis. forthcoming. 
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