Hedge Fund Leverage

the "repurchase" market or "repo" market, allows institutions to borrow
money at favorable rates because the loans are secured by extremely high-
quality collateral. Hedge funds can borrow money to finance Treasury
bond positions at rates very close to the U.S. Treasury bill rates. Traders
can borrow nearly 100 percent of the market value of some types of bonds.
Less liquid bonds and less creditworthy bonds can be financed at slightly
higher rates and are subject to excess collateralization (called a "haircut")
of 10 percent or more.
The stock loan market evolved based on the model of the government
securities markets. Like the repo market, the stock loan market allows bor-
rowers to finance positions at rates close to Treasury bill rates. Rates in the
stock loan market are typically 50 basis points higher (100 basis points
equals 1 percent) than repo rates. Stock traders can typically borrow up to
90 percent of the market value of liquid equity positions. Other limitations
on leverage (including regulations such as the U.S. Federal Reserve's Regu-
lation T and credit limits imposed by counterparties) may limit hedge fund
position size.
Suppose a hedge fund owns a position in a particular common stock
worth $1 million. If the fund must maintain a haircut of 10 percent, it can
borrow $900,000 in the stock loan market. The fund delivers the shares to
the lender to hold as collateral. At the end of the loan period, the lender re-
turns the shares to the owner, who repays the loan plus interest.
Typically, interest is calculated based on the actual/360 convention
whereby interest is calculated based on the actual number of days in the
loan but the annualized interest rate is prorated as if a year had 360 days.
For example, a $900,000 loan at 5 percent to finance a stock position
would cost the hedge fund $875 ($900,000
x 5% x 7 days/360 days).
The repo market works similarly except the value of the bond posi-
tion includes accrued interest. For example, if the hedge fund owned $1
million face value of bonds with a current price of $102 and accrued in-
terest of a half point, the value of the position is $1,025,000
($1,000,000 face
x 102.5% of face). Also, haircuts are much lower on
bonds than on equities. The haircut for a U.S. Treasury with a maturity
of five years or less may be a quarter of 1 percent or less. The hedge fund
may be able to set a repo balance as high as $1,022,437.50 ($1,025,000
x 99.75%). Also, financing rates are somewhat lower for bonds, espe-
cially for Treasury and agency bonds. Assuming the fund can borrow
money at 4.5 percent, interest on this repo for a week would equal
$894.63 ($1,022,437.50
x 4.5% x 7/360).
In practice, the hedge fund would finance a significantly lower portion
of the total value of stocks or bonds in the portfolio than in the example.
Usually, the principal amount would also be set to a rounded amount.
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