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You may also like We use cookies on our site to improve your user experience. If you continue to use this website we will assume you are happy with our use of cookies. read moreQ: Leverage (not to be confused with leverage) and risk parity I'm confused on one thing regarding leverage. As per wiki, it is a position-dependent risk measure. If I understand correctly, it implies that there's a risk premium on some assets because they are not risk free. What I don't understand is how one can take a position with high leverage and argue that the risks are mitigated because we take a position which is not exposed to losses. I understand that this is what risk parity is about. But how can we take a position with high leverage? We should be exposed to losses, right? A: Yes, you can hedge risk with high leverage. There is no violation of the capital requirement of a company. The company has a high leverage ratio (in the context of a bank it could be 10x or 100x). The company can either put in more capital or borrow funds with lower cost and charge interest on the loan. In this case the company borrows from the bank which is at a lower cost than putting money in. The bank has a higher risk of default as it has to fund the risk of the loan. The bank can default on the loan and the bank has to re-imburse the company. The company has a higher risk but lower cost. The capital requirement of the bank was set at a level where it is safe for the bank and the cost of the loans were set at a level where the profit is higher than the default cost of the loans. Thus the net worth of the company and the bank has increased. You may look at the company as a risk position which is being offset by the bank as a low risk position. The bank's risk is being offset by the loan with a lower default cost. The overall risk profile of the bank is better due to lower default cost and higher profit. Similarly with a high leverage position. The company borrows from a bank or hedge fund or private investors at a lower cost than the company has to fund the risk. The company has higher risk as it needs to borrow funds and it needs to pay interest to fund the risk. The bank or investors is a low risk position and the profit from the loans or





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