7 – M4 L1A 07 Rescale Part 1 V2

Okay. Now, let’s get an idea for why we re-scale the weights so that the sum of the absolute values equals one. Our goal is for the portfolio’s leverage ratio to be equal to one. So, let’s first discuss the concept of leverage, and then we’ll learn about what the leverage ratio is. Leverage is the act of borrowing in order to invest in assets. Usually, the goal when using leverage is to potentially increase the return on investment. Leverage is related to the word leverage as used in physics. You can think of a lever resting on a fulcrum. If you push the short side of the lever down by one meter, the long side will move by more than one meter. For a long/short portfolio, the money that is borrowed for leverage can come from borrowing cash and also from taking short positions in stocks. Recall that to take a short position, we borrow an asset and sell it in the market with a promise of buying it back in the future. We can use the cash received from these short positions in order to buy other stocks in the portfolio. Without leverage, if we invested in a stock, then a 10 percent change in the stock price would lead to a 10 percent change relative to our initial invested capital. With leverage, if we borrowed cash to double our initial investment, then a 10 percent change in the stock price will lead to a 20 percent increase relative to our initial capital. Let’s look at an example without leverage. Pretend that we have $100,000 as initial capital. If the stock price increases by 10 percent, then the portfolio gains $10,000. Relative to the initial capital, the investment increased 10 percent. Now, let’s look at a scenario where we use leverage. Start with $100,000 of initial capital. Borrow 100,000 in cash. Use the 200,000 in cash to invest in the stock. If the stock increases by 10 percent, then the investment increases by $20,000. Relative to the initial capital of 100,000, this is actually an increase of 20 percent. Since the potential investment percent gain of 20 percent is greater than the stock price gain of 10 percent, we say that this position is leveraged. Feel free to pause the video to study this.