Limited Liability Leverage (L^3): A New Measure of Leverage

Abstract

Average leverage is often used as a measure of risk. However, average leverage in a limited liability context should not be computed as a simple arithmetic average of the underlying constituents. In fact, using a simple arithmetic average can give misleading results. For example, the simple arithmetic average leverage may give results which run counter to the actual risk exposure for certain portfolios. This paper introduces a new measure, Limited Liability Leverage (L3), which corrects the simple average for the limited liability framework. This new measure is discussed in the context of a portfolio of hedge funds and compared to a multi-strategy hedge fund structure, where trading units do not have limited liability. This perspective can also be extended to reflect the lower risk of a financial system with many small institutions relative to a system with large, “too-big-to-fail” institutions.

Keywords: Leverage, risk measurement, hedge funds, funds of funds, limited liability

JEL Classification: G32, G33, G21, G23