Embedded Leverage

Topics - Macroeconomics Market Risk and Efficiency

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Embedded Leverage

AQR Working Paper

Embedded leverage — that is, the amount of market exposure per unit of committed capital — has become an important feature of financial instruments. This is because investors are unable (or unwilling) to use enough outright leverage to get the market exposures they would like.

For instance, individual investors and pension funds may not be able to use any leverage, banks face regulatory capital constraints, and hedge funds must satisfy their margin requirements. However, an investor can gain substantial market exposure without using outright leverage (i.e., without borrowing) by buying options, leveraged exchange-traded funds (ETFs) or other securities that embed leverage —many of them designed precisely to provide embedded leverage. Investors are therefore willing to pay a premium for securities with embedded leverage and intermediaries who meet this demand need to be compensated for their risk.

This paper studies the amount of embedded leverage in equity options, index options and ETFs, and how embedded leverage affects the required returns. We find strong evidence for the pricing of embedded leverage both for equity options, index options, and leveraged ETFs. We propose that a security’s embedded leverage is an important characteristic. Securities with a large amount of embedded leverage alleviate investors’ leverage constraints and, therefore, have a lower required return, according to our hypothesis.

Embedded leverage may have broader effects on the financial markets than the asset classes that we study. For instance, equities in firms with debt are securities with embedded leverage on the firm value. Also, the whole securitization market may be affected by embedded leverage considerations.

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

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This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.

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