Sunday, January 22, 2012

Leverage - Analysis

Leveraging in simply increasing your exposure in something with some money that you don't have and thereby inherently increasing the risk.

Typical example for a normal common man would be 'Buying a house' - Where most of the money is given as a loan by the bank and he is thus said to be leveraged.

For a equity investor, few of the other examples would include Stock Futures, Options and Margin Intraday trading.

Without the money in hand, only the risk will be increased in each of the case and typically Leveraging is the concept where you will be get high returns along with high risk.

For example, Reliance is at Rs. 800/- now. you think, it will go Rs. 860/- in next 3 days.

You have Rs. 5000/- in hand, which you can afford to lose. Remember, you shouldn't be taking risk on a capital that is required next day for your need.

Option 1:
Buy 6 shares
- 6 * 800 - Rs.4800 spent.

- 60 * 6 - Rs. 360/-

Option 2:
Buy 60 shares
- 60 * 800 - Rs. 48000 spent (Rs. 43000 in margin)

- 60 * 60 - Rs. 3600/-

You can clearly see that Leveraging gives you a greater benefit in rewarding. But it goes without saying that it has higher risk. What if, Reliance goes down?

If you have bought only 6 shares, you can afford to hold it. But if you have bought in margin you are locked. You have to book losses and the losses would be heavy as well.

So, Leveraging would help in having high risk and give high rewards.

Liquidity - Analysis

An asset is said to be more liquid if it can be converted to cash quickly, without changing much of its value. Gold, Cash, good blue-chip Stocks are excellent examples of liquid assets.

Real estate, PPF, ULIPs and other complex products are excellent examples of illiquid assets.
PPF is safe but illiquid as it has a lock-in period.

So, why does it really matter to me?
It is important to have some emergency fund in liquid form. If your expenses for a month is around Rs. X/-, you need to have Rs. 6X/- as contingency emergency fund in liquid form.

How does it affect a bank or investment bank?
Bank lends money based on the documents and collateral. If the collateral is a illiquid asset, the risk is more. They might not be able to get the money on time.

Investment banks and Hedge funds also creates complex products to help banks in creating more money to lend more. If the underlying asset is illiquid, the risk would be more.

The risk is actually, we might not able to sell the asset at the right price at the right time and cannot generate the cash-flow required at the stipulated time. So, automatically we have to bend to reduce our price for the asset which could be valued more if it could be sold without any hurry.

To generate more returns on the personal front for the contingency fund and to have it in liquid form, we can have some part in savings bank, some part in liquid fund and some more in sweep-in FD/index fund. What do you think?

Where do you keep your contingency funds?