Analysis of Asset Allocation

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Financial Leverage : Advance Ratios
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Leveraging a portfolio is dangerous. The purpose of this section is not to encourage you to borrow money but well to explain the leverage mechanisms.

PRINCIPLE

If you give your portfolio as a guarantee to a credit facility to your financial institution, this last will compute a 'borrowing power' of your portfolio based on the quality of the underlying investments. The money you will receive is based on the cover value.

Generally the credit institution has an advance ratio for each investment or each category of investment. Each credit institution fixes his own advance ratios and they are often quite different from one institution to the other.

The basic principle is that the credit institutions will give a higher advance ratio to less risky instrument (like treasury bonds) than to more risky share (like an highly volatile stock listed on the NASDAQ).

The idea behind leverage is to increase the total return of your portfolio. If you think the market will go up, you can borrow to purchase additional securities. It works provided the the return on the additional securities is higher than the price you pay for the loan. But if the market is not going, even temporarily, in the direction you wish to, you take the risk that the credit institution sells your entire portfolio to cover the loan. If that happens, you can lose all your portfolio. This will be more deeply analyzed in the 'dangers' section.

During all the lifetime of your loan, the credit institution will monitor the market value and the cover value (market value adjusted by the advance ratios) of your portfolio.

If your loan is much lower than the collateral value of your portfolio, the credit institution will do nothing. Once the collateral (cover) value is closed to the value of your loan, the credit institution will take action. The action depends of the credit institution but it can go up to sell your entire portfolio. If, despite all the dangers of this strategy, you wish to leverage your portfolio, you will try to bring your attention to all the points you should look at before entering in such a transaction.

 


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