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Leverage is using given resources in such a way that the potential positive or negative outcome is magnified. Most commonly in finance leverage takes the form of borrowing money from a lender to reinvest it into another project or investment earning a greater rate of return than the interest cost. The use of leverage thus allows greater potential return to the investor than otherwise would have been available. The potential for loss is greater because if the investment becomes worthless, not only is that money lost, but the loan still needs to be repaid. A margin account is a common way of utilizing the concept of leverage in investingBusinesses also utilize leverage. A profitable business with good credit and cash flow may be able to borrow at rates well below the rate at which they can earn money in their core business or other projects by utilizing the borrowed capital. Several methods are used to look at what rate of return a corporation can earn money. See return on assets and return on equity . Any time a business can earn more money than what they can borrow at, the corporation will be more profitable over the period of time in which they can do so.
Another form of creating leverage using financial intruments is through the use of options. The purchase of a call option on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument.
Leverage and Risk
Utilizing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. This increased risk may be perfectly acceptable or even necessary to reach the goals of the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and securities purchases, is the subject of a discipline known as financial engineering
