Contemporary Finance

11Leverage

11.1 Defining and Measuring Leverage

11.1.1 Company Financing

Financial leverage is used extensively in banking, trading, investment, and by nonfinancial firms and takes many institutional forms. For a firm, leverage measures the funding of assets by issuance of debt relative to shareholders’ equity, the firm owners’ own resources. A thinner equity share increases default risk, the likelihood that asset value falls sharply enough to deplete it entirely.

Most nonfinancial firms fund themselves at least partly through debt. Even small firms routinely have some short-term debt to suppliers and other business outstanding. Financial firms typically employ more leverage than nonfinancial firms as an essential aspect of how they carry out intermediation, and as part of a larger system for distributing leverage and liquidity risks through the financial system. Banks and other financial intermediaries are highly exposed to credit risk because of the extensive leverage they employ. Some form of leverage and collateralization is involved in derivatives transactions, such as futures, swaps and options, and in establishing short positions. Other markets and financial instruments, such as the collateralized securities lending and structured product markets, have been developed in large part to facilitate secured borrowing.

We defined leverage in Chapter 9 as the ratio of assets ...