Which statement best describes leverage in relation to risk and return?

Which statement best describes leverage in relation to risk and return?

• A. Higher leverage generally increases both potential return and risk.
• B. Higher leverage reduces both potential return and risk.
• C. Higher leverage has no effect on risk.
• D. Higher leverage guarantees higher returns.

Answer: (A)

Leveraging means using borrowed money to fund an investment, so you’re putting more dollars at work than your own cash alone. That amplification changes both sides of the equation: if the investment performs well, the gains are spread across a smaller base of equity, so the return on equity rises; if the investment performs poorly, debt obligations still must be paid, and losses hit the equity harder. In other words, leverage makes the upside bigger and the downside bigger as well, so higher leverage tends to increase both potential return and risk. It doesn’t guarantee higher returns—returns depend on how the asset performs relative to the cost of the debt—and it can backfire if performance falters.

Leveraging means using borrowed money to fund an investment, so you’re putting more dollars at work than your own cash alone. That amplification changes both sides of the equation: if the investment performs well, the gains are spread across a smaller base of equity, so the return on equity rises; if the investment performs poorly, debt obligations still must be paid, and losses hit the equity harder. In other words, leverage makes the upside bigger and the downside bigger as well, so higher leverage tends to increase both potential return and risk. It doesn’t guarantee higher returns—returns depend on how the asset performs relative to the cost of the debt—and it can backfire if performance falters.