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:
- The investor has $1,000,000 to invest.
- The investor purchases $2,000,000 worth of stock.
- S/he borrows half, or $1,000,000.
- Therefore, their “LMV,” or “long-market value” is $2,000,000 and their loan is $1,000,000.
- S/he now has a leveraged investment with equity of $1,000,000.
De-leveraging:
- The investor has $1,000,000 to invest.
- S/he invests half, i.e., $500,000, in stock.
- S/he lends half, i.e., $500,000.
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- S/he can lend simply by buying Treasuries to, in effect, be a lender – to the government.
- Therefore, his/her “long-market (stock) value, or “LMV,” is $500,000, and his/her loan asset is $500,000.
- S/he has now de-leveraged his/her leveraged stock investment.