CFA Level I · CFA Level I Exam · Types of Financial Returns
A fund uses leverage by borrowing an amount equal to 50% of its own equity at 4%. Its unlevered portfolio returns −6% over the year. The return on equity is closest to:
The return on equity is about −11.0%. With 100 of equity and 50 borrowed, the 150 portfolio loses 9 and the loan costs 2 in interest, a total loss of 11 on 100 of equity. Leverage magnifies the loss and interest adds to it.
- A−11.0%Correct
- B−8.0%
- C−6.0%
Explanation
Take equity of 100, borrowings of 50, assets of 150. Portfolio loss = 150 × 6% = 9. Interest = 50 × 4% = 2. Total loss = 11 on equity of 100 = −11.0%. Using −6% − 2% ignores leverage on the loss, and −6% ignores both leverage and interest.
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