Financial Leverage: Risks and Performance in Hedge Fund Strategies

Abstract:     
This document affronts the issue of financial leverage in Hedge Funds, with a different approach than that which currently appears in the literature about this subject. Financial Leverage is not considered a risk factor (equal to other traditional market risk factors) through which we can explain the performance and volatility of single Hedge Funds. With a point of view related to traditional balances sought after by corporate financing, Financial Leverage is examined as a decisional variable of the manager, and as a source of risk for the financier, evaluating the impact on the efficiency of the strategy for the investor (the shareholder).

This document takes its starting point from the distinction between the business risk of the strategy and the financial risk of the strategy, observing the impact of the use of leverage on the risk adjusted performance. Financial Leverage seems to have a large responsibility in contributing to systemic crises. Given the business risk of the strategy, it is possible to determine the maximum level of Financial Leverage that the strategy is able to support ex ante. This may be done empirically, based on historic series of Hedge Fund indices and theoretically by using the Merton Model.

Keywords: hedge funds, financial leverage, risk adjusted performance

JEL Classifications: G29

Working Paper Series