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Abstract
Borrowing and leverage are two related concepts that are often conflated, however each has distinct risks. Leverage refers to any technique to multiply the gains and losses on an investment. Borrowing is one way to achieve leverage, but you can borrow without levering and lever without borrowing. Keeping the terms straight is essential for evaluating risk. The cases described in this article are straight from Finance 101, although a lot of practitioners and people who write about finance would have trouble passing that course. Leverage allows hedging, which remains an essential tool for risk management. It also improves liquidity, allowing investors to hold large cash cushions and still have all their capital deployed. Leverage improves diversification, still the only free lunch in finance. To get a decent return with nominally unlevered assets, you are forced to concentrate on assets with embedded leverage, like equities. Diversifying into levered bonds, commodities and other assets reduces risk without hurting expected returns.