Leverage is an increasingly popular tool for investors of all sizes. Hedge funds have been at the center of attention when it comes to leverage, because a few have failed, leading the media to pay great attention to the drama surrounding such circumstances. Unfortunately though, too little consideration is given to the learning opportunities these failures represent for individual investors.

The fact is the mistakes of others, especially the purported intellectual and social elite of the hedge fund universe, offer wonderful examples of how not to use leverage. With that in mind, let’s take a look at leveraged hedge fund strategies and the factors that can and do contribute to their failure.

The Strategies

To begin, consider the following two hedge fund strategies that entail substantial amounts of leverage:

Currency Carry Trade

The currency carry trade strategy is based on the principle of taking advantage of interest rate and currency differentials among the economies of the world. More specifically, it entails borrowing money in a nation (or currency) with low interest rates and investing in a nation (or currency) with high interest rates. On an absolute basis, this type of trade will only result in single-digit rates of return. However, leverage can quickly solve that dilemma.

Interestingly, this is one hedge fund strategy that any individual investor can perform with only a futures trading account. In fact, it is as simple as selling short a futures contract on the low interest rate currency (or borrowing at that rate) and going long a futures contract on the high interest rate currency (or investing at that rate). This is generally what hedge funds do, as futures markets are a very liquid and efficient means to implement this strategy.

Furthermore, given the very low margin requirements for futures contracts, it is easy to apply substantial amounts of leverage. To illustrate, consider the following example of a carry trade through futures contracts that assumes the following:

• The initial outlay is $100.
• $10 purchases $100 in notional carry trade exposure.
• The remaining $90 stays in the money market as margin .
• Cash rates are 4%.
• The embedded cost of capital for the futures contract is 4%. (The embedded cost of capital is a drag on performance of futures contract. For example, if cash rates were 10% for an S&P 500 futures contract and you held the contract until maturity, your return would be the S&P 500’s return less 10%.)
• Short (or borrow) in a currency with a 1% yield (i.e. Japanese yen).
• Long (or invest) in a currency with an 8% yield (i.e. New Zealand dollar).
• The investment period is one year.

$100 in Notional Carry Trade Value/$10 in Futures