Hedge Fund Leverage

together. Suppose a second asset was bought that was only 40 percent cor-
related with the unleveraged portfolio. That is, for every dollar in capital,
the fund buys $1 of one asset and $1 of a second asset that is correlated 40
percent to the first (leverage 2:1).
Although the portfolio contains as much leverage as the examples
shown in Figures 6.1 and 6.2, the diversification reduces the standard devi-
ation of the portfolio to 30.12 percent, down from 36 percent. As can be
seen in Figure 6.3, the portfolio has about the same probability of loss
(20.3 percent)
5
as an unleveraged portfolio (20.2 percent). It is clear, how-
ever, that the chance of large losses is higher on the levered portfolio. In re-
turn, this levered portfolio also has a considerably higher probability of
large gains.
Risk in a Levered, Hedged Portfolio
Hedge funds commonly construct portfolios so that the risk of the long
positions is significantly mitigated by the risk of the short positions.
(This kind of position is called a hedge or arbitrage.) Two nearly identi-
cal positions behave almost exactly opposite each other if one position
is held long and the other is held short. When analyzing the returns of
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HEDGE FUND COURSE
FIGURE 6.3
Distribution of Returns
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