Consider two portfolios. One portfolio consists of a $10,000 investment in AAPL, and the other also...

Consider two portfolios. One portfolio consists of a $10,000 investment in AAPL, and the other also consists of a $10,000 investment in AAPL, but with 50% leverage ($5,000 of the investor's capital, $5,000 borrowed). Now consider two separate moves in the value of AAPL; a 10% upside return and a 10% downside return. Explain the effect of leverage on the volatility and return by comparing the performance of each portfolio.

Expert Solution

	Option 1	Option 2
Portofolio value	10,000	10,000
Investment amount	10,000	5,000
Margin amount	-	5,000
Leverage	0%	50%

10% upside move
Profit	1,000	1,000
Return on investment	10%	20%

10% downside move
Loss	-1,000	-1,000
Return on investment	-10%	-20%

Leverage makes the investment more volatile. Since the profit / loss will be calculated on portfolio value. However investment made in lower than the exposure take.

Standard deviation (Volatility) of levered investment = Standard deviation (Volatility) of levered investment x 1/leverage

In above case, we can observe that option 2 is riskier than option 1 since the return on investment has more impact in option 2 compared to option 1 in similar type of movement.

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jeff jeffy answered 1 year ago

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