Financial leverage is named after a lever in physics, which amplifies a small input force into a greater output force, because successful leverage amplifies the smaller amounts of money needed for borrowing into large amounts of profit.
Securities like options and futures are effectively leveraged bets between parties where the principal is implicitly borrowed and lent at interest rates of very short treasury bills.
The more it borrows, the less equity it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.
[4][5] Hedge funds may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.
[6] National regulators began imposing formal capital requirements in the 1980s, and by 1988 most large multinational banks were held to the Basel I standard.
[7] While Basel I is generally credited with improving bank risk management it suffered from two main defects.
Consumers in the United States and many other developed countries had high levels of debt relative to their wages and the value of collateral assets.
At the end of 2007, Lehman had $738 billion of notional derivatives in addition to the assets above, plus significant off-balance sheet exposures to special purpose entities, structured investment vehicles and conduits, plus various lending commitments, contractual payments and contingent obligations.
[9] On the other hand, almost half of Lehman's balance sheet consisted of closely offsetting positions and very-low-risk assets, such as regulatory deposits.
Even if cash flows and profits are sufficient to maintain the ongoing borrowing costs, loans may be called-in.
This may happen exactly at a time when there is little market liquidity, i.e. a paucity of buyers, and sales by others are depressing prices.
This can lead to rapid ruin, for even if the underlying asset value decline is mild or temporary[11] the debt-financing may be only short-term, and thus due for immediate repayment.
[11] Or if an investor uses a fraction of his or her portfolio to margin stock index futures (high risk) and puts the rest in a low-risk money-market fund, he or she might have the same volatility and expected return as an investor in an unlevered low-risk equity-index fund.
[12] Or if both long and short positions are held by a pairs-trading stock strategy the matching and off-setting economic leverage may lower overall risk levels.
So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one.
[11] The term leverage is used differently in investments and corporate finance, and has multiple definitions in each field.