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Leveraged portfolio return

I don’t understand this referring to s note.

“Borrowing is normally done at shorter tern interest rate and those costs can increase faster than return on asset if interest rates increase. I.e. the asset duration normally exceeds the liability duration in a leveraged portfolio.”

Why normally asset duration exceeds liability duration ?

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In a normal market, yield curves are upward-sloping (i.e. long-term yields > short-term yields). So investing in long-term assets (i.e. higher duration assets) will yield a higher return. In order to gain from a leveraged position, the investor will borrow using short-term repos for example (i.e. lower duration liabilities) and invest into long-term assets.

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However this may result into cash flow risk because of short term redemption.

Further the roll over risk cannot be discounted

Further, the associated transaction and admin cost cannot be overruled

Further your ALM deptt. will have put in longer hours

back against the wall. no retreat no surrender.

jung hyun park wrote:

Why normally asset duration exceeds liability duration ?

Investments can yield high rates and also be relatively illiquid (ie. real estate), so their investment horizon can be long (3, 5, 10+ years). Also, you are short on capital, so you get debt. The question is what kind of debt you take? ALM department of a bank would say “debt with the same duration as the asset duration”. Hedge Funds would say “the cheapest debt available”, 60-day loans or even shorter.

As people say above, there are pros and cons of the strategy the hedge fund chooses, but the idea is to benefit from yield gaps.

Las almas de todos los hombres son inmortales, pero las almas de los justos son inmortales y divinas.
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