AllAboutAlpha.com – The Bank for International Settlements in Basel, Switzerland was probably abuzz last week watching history unfold before its eyes. After all, one of the lynchpins of the organization’s Basel II Accord was the requirement for banks to mark-to-market all assets – including less liquid ones. And it appears that doing so in a leveraged environment has put several banks into a death spiral in recent weeks (see featured post below).
But the BIS is also keeping an eye on hedge fund leverage. The organization just released a working paper called “Estimating Hedge Fund Leverage” that proposes a new method of calculating the level of leverage used by hedge funds and, it is hoped, a way to measure any resulting systemic risks to the financial system. Regular readers may remember that this topic was also covered by the Fed’s Tobias Adrian last year.
As the authors of this report point out, leverage comes in two basic forms: funding leverage – where you literally borrow money to goose returns (or losses) and instrument leverage – where the securities themselves have leverage baked in (such as a futures contract, option or swap). But at the end of the day, if a fund rises twice as much as the market on “up” days and falls twice as much on “down” days, then the source of leverage is less relevant. In fact, divining leverage based on historical returns will also capture the leverage implicit in the balance sheets or business models of individual securities.