UK: THE RISKS OF LEVERAGING - WHEN YOU HAVE TO PAY UP MORE THAN YOU PUT UP.

UK: THE RISKS OF LEVERAGING - WHEN YOU HAVE TO PAY UP MORE THAN YOU PUT UP. - The ease with which they can be geared up is one of the main attractions of derivatives. Investors need put up only 5-8% of the value of the underlying security, so a move of 1

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Last Updated: 31 Aug 2010

The ease with which they can be geared up is one of the main attractions of derivatives. Investors need put up only 5-8% of the value of the underlying security, so a move of 10% in the right direction can more than double the initial investment. But a move in the wrong direction can leave the holder of a futures contract with an obligation to pay out more than he has put up.

Some hedge funds even borrow the initial 5-8%. A fund may borrow £2 million against £1 million of capital. With this £3 million it is possible to buy futures with an underlying value of £60 million. A 2% adverse movement in the underlying security may then wipe out the entire capital investment.

When leveraging like this goes wrong, as happened to the big hedge funds in 1994, huge investment positions - totally disproportionate to their underlying capital base - may rapidly be unwound. Academics, traders and responsible funds managers argue over whether this creates greater volatility in the underlying markets for shares, bonds and other securities. Most of the academics believe it does not increase volatility significantly. Many fund managers say that it does.

'There really doesn't have to be increased volatility because the instruments in question are spread over many markets,' argues Anthony Neuberger, a research fellow specialising in derivatives at London Business School. This view is supported by other British academics. A research study undertaken by John Board of the London School of Economicis and Charles Sutcliffe of Southampton University concludes: 'There is no evidence that the existence of futures markets has caused an increase in the volatility of the spot market.' Others think differently. 'The academics are nuts,' concludes Michael Hyman, chief executive of GH Asset Management, a London-based fund with $1 billion in assets, all from major institutional investors. 'I haven't a clue where they get their data. Just look at the property market and how leveraging increased volatility. I think the professors are out there circling planet Venus.'.

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