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Comment by jackcosgrove | Hacker News Reader

I understand how positions can offset and cancel each other out. What I don't understand is if the notional value is never fully redeemed, why use leverage at all? That is, if only the spot prices are used to actually exchange money, why inflate the value of a trade with leverage?

I apologize if I'm misusing terms - I'm not a finance expert.

The only explanation I can think of is that leverage is used to exploit dumb money that isn't hedged correctly. In which case, leverage is a barrier to entry that diminishes the number of participants in a market and reinforces cartel behavior. Which I would think is a bad thing.

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The notional is purely a reference amount. For the vast majority of derivatives the notional amount is never exchanged (cross-currency basis swaps being a notable exception).

E.g a simple interest rate swap: I agree to pay you 2% per annum on a reference notional of 100m for 10 years, and in exchange you pay me libor referencing the same notional. At the end of first year let's say libor fixes at 1.98%. Hence I pay you a net 0.02% (2% - 1.98%) of 100m, i.e 20,000. We do this every year for 10 years.

It is just a way to hedge interest rate exposure - e.g I have borrowed 100m paying a Libor-linked interest rate and don't want to run the risk that Libor spikes to 10% or whatever.

There's nothing complicated about this, at least in principle. Derivatives just allow people to hedge out exposures they don't want.

I see. So if you pay cash now you are vulnerable to interest rate swings. Whereas if you use leverage to spread the term of your investment out, you can average the interest rate across the business cycle and achieve more predictable behavior. Is that correct?

I think point of the example was not to say that you could use leverage. You're borrowing the same amount that you're lending.

The idea of the interest rate swap is simply that some entities prefer to lock in a rate, others prefer to have it float. So they swap those risks.

Consider that borrowing 10 year money at the 6-month LIBOR rate is equivalent to borrowing at LIBOR for 6 months and rolling the debt 19 times.

The swap market provides a linkage between the money market ( borrowing < 1 year) and the capital market (borrowing > 1 year), and allows one to borrow (or lend) where the comparative advantage is better.

The 10 year swap rate is then a market number which represents the relative demand (and supply) within the money & capital markets.

Well, leverage is kind of a separate is from whether or not your entering into a derivative contract or making an investment in the underlying asset. Bu the simple answer is, the more you lever up any investment, the more money you stand to make.

Or lose.

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