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LEVERAGE and Diversification

This paper discusses how leverage can undermine the benefits of diversification for a portfolio. While diversification reduces risk by combining uncorrelated risks, leverage compounds new risks on top of existing risks. This can actually increase overall portfolio risk rather than decrease it. The paper uses the example of a pension plan adding a currency overlay strategy to illustrate this point. While the overlay provides new diversification, it also introduces leverage through the use of currency forwards. The trustees incorrectly assume this will reduce risk, but it will likely have the net effect of increasing risk through the leverage effect. The paper explains how diversification through reallocation of risks reduces risk, while diversification achieved through leverage often increases risk. It provides simple formulas to demonstrate how expected returns

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46 views7 pages

LEVERAGE and Diversification

This paper discusses how leverage can undermine the benefits of diversification for a portfolio. While diversification reduces risk by combining uncorrelated risks, leverage compounds new risks on top of existing risks. This can actually increase overall portfolio risk rather than decrease it. The paper uses the example of a pension plan adding a currency overlay strategy to illustrate this point. While the overlay provides new diversification, it also introduces leverage through the use of currency forwards. The trustees incorrectly assume this will reduce risk, but it will likely have the net effect of increasing risk through the leverage effect. The paper explains how diversification through reallocation of risks reduces risk, while diversification achieved through leverage often increases risk. It provides simple formulas to demonstrate how expected returns

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TechnoGraphics TG
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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