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CFA Level I · CFA Level I Exam · Returns of Financial Assets and Instruments

Compared with an unleveraged position in the same asset, the use of borrowed funds at an interest rate below the asset's return is most likely to:

Leverage magnifies both gains and losses on the investor's equity. Borrowing increases exposure relative to the investor's own capital, so returns above the borrowing cost are amplified, while poor outcomes produce larger losses. It does not reduce or eliminate risk.

  1. Areduce both the gains and losses on the investor's equity
  2. Bmagnify both the gains and losses on the investor's equityCorrect
  3. Celiminate the risk of loss on the investor's equity

Explanation

Leverage multiplies the exposure relative to equity, so returns on equity are amplified in both directions. When asset returns exceed the borrowing cost, gains rise; when they fall short or are negative, losses are larger. Leverage never removes loss risk.

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