6.3 Leveraging versus De-leveraging

We will use brand new numbers. Let’s say an investor has $1,000,000 to invest. There are two basic possibilities given whatever their desired leverage ratio is. They can purchase a non-leveraged firm and leverage it using homemade leverage, or they can buy a leveraged stock and de-leverage it.

Leveraging:

1. The investor has $1,000,000 to invest.
2. The investor purchases $2,000,000 worth of stock.
3. S/he borrows half, or $1,000,000.
4. Therefore, their “LMV,” or “long-market value” is $2,000,000 and their loan is $1,000,000.
5. S/he now has a leveraged investment with equity of $1,000,000.

De-leveraging:

1. The investor has $1,000,000 to invest.
2. S/he invests half, i.e., $500,000, in stock.
3. S/he lends half, i.e., $500,000.

• • S/he can lend simply by buying Treasuries to, in effect, be a lender – to the government.

4. Therefore, his/her “long-market (stock) value, or “LMV,” is $500,000, and his/her loan asset is $500,000.
5. S/he has now de-leveraged his/her leveraged stock investment.