What is the risk associated with the use of leverage?
What will be an ideal response?
A portfolio manager can create leverage by borrowing funds in order to acquire a position in the market that is greater than if only cash were invested. The funds available to invest without borrowing are referred to as the "equity. The basic principle in using leverage is that a manager wants to earn a return on the borrowed funds that is greater than the cost of the borrowed funds. The return from borrowing funds is produced from a higher income and/or greater price appreciation relative to a scenario in which no funds are borrowed. The risk associated with leverage (or borrowing funds) is that the securities in which the borrowed funds are invested may earn less than the cost of the borrowed funds due to failure to generate interest income plus capital appreciation as expected when the funds were borrowed. Generally speaking borrowed funds create a legal responsibility on the part of the borrower and can lead to default if not paid back in a timely fashion.
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