March 2010
Vol. 2 No. 1

Lessons from the Woodshop:
Common Sense in Managing and Measuring
LeverageT

he use of borrowed money is a subject of

Put simply, folks think a lot about the question, “Howvigorous debate, particularly since the onset ofmuch leverage?” but not very much at all about thethe credit crisis.

Whether in the context ofquestions, “Why is the leverage being used?”, “Under

national balances of payment, company balance sheets,

what terms and conditions is the borrowing being done?”,investment fund risk profiles, or household finances, the use

and “How is the leverage quantity being computed?”of leverage tends to elicit strongly held views.
This installment of Market Insights examines two broad
aspects of leverage that merit consideration by investors
evaluating levered investment portfolios. First, we believethat many observers ascribe much importance to thequantity of leverage used, but not nearly enough to its
quality and intended purpose.

Second, investment

managers, investors, and regulators often employ different
and inconsistent methods of measuring leverage.

Lessons from the Woodshop
Remember the Woodshop TeacherLeverage and power tools share three fundamental
properties: they can be extremely helpful, they canallow for far greater precision, and they can bereally dangerous, even in the hands of experts. We would
wager that some of us who took a woodshop or metalshop
class in high school had instructors—however masterful acarpenter or machinist—who were missing at least one
finger due to a moment of inattention while operating atable saw.
Let’s immediately make the obvious point that access toleverage creates opportunity and potential risk. The simplest
objective of leverage is to do more with less. As an
example, leverage can allow investors with higher returntargets to invest in assets with expected unlevered returns
that don’t meet their bogey. For some investment
strategies, especially in the fixed-income and currency
spaces, leverage creates the economic basis for exploiting
small market inefficiencies that may not be sufficiently
profitable on an unlevered basis.
At the same time, though, leverage can be used to amplify
risks to which a portfolio is already intentionally orunintentionally exposed. The following are some of thoserisks.

 Volatility amplification—Leverage can increase the sizeof a portfolio’s exposure to a given investment, and, inturn, the increase in exposure would result in higher
volatility and risk.
 Loss-liquidation-loss feedback loops—Levered investors
can lose more than all of their invested capital.
Consequently, an investor who employs leverage may
leave himself vulnerable to a self-reinforcing downward
spiral when the price of an asset moves against him.
Concentrated exposure to a financed asset means that a
relatively small price move could translate into a large
capital loss, which may in turn force the investor to sell
assets to meet margin calls. The sale of assets then puts
further downward pressure on the asset’s price, creatinga familiar, vicious cycle of margin calls, forced sales, andadverse price movements. This contrasts with unlevered
investors who, in the absence of margin calls, are nevercompelled to liquidate if they prefer not to.

leverage introduces a new and distinct set of financing risk
factors. Broadly speaking, these financing-related risks canbe grouped into two categories.

 Counterparty risk—A borrower has exposure to thelender if, for example, collateral the borrower has posted
with the lender were to become inaccessible or to vanish
altogether with the lender’s insolvency.
 Funding instability—Just as investors must pay attention
to the stability of their equity capital base, they also must
anticipate instability in their debt. (It seems to us, by theway, that many market observers pay far too little
attention to debt stability, about which we’ll say more ina moment.) This instability takes its most spectacularform in a “run on the bank” scenario like the following:
imagine that an investor suffers from an unstablefinancing structure and that this weakness becomesrecognized by the Street. His leverage providers thenbegin defensively pulling their credit lines to him, which
in turn could force the investor to sell assets. Exiting a
position under duress will likely cause a loss of capital,
which can broaden or exacerbate the loss of funding(particularly if the leverage contract is subject to the”NAV triggers” common in many lending arrangements),
and so forth, until the investor’s financing dries up
completely and his portfolio has suffered substantial
losses. In this case, the vicious cycle was probably notinitiated by an adverse general market event, but insteadby some more specific cause. Examples of precipitating
local events might be the expiration of the investor’s
leverage arrangement, a lender that encounters liquidity
problems, a sudden change in the investor’s leverageterms, a financial report or disclosure that brings thefinancing structure to light, or exploitative behavior bymarket participants seeking to capitalize on the apparent
or merely potential distress of the investor.
Risk-Reduction through Leverage?
Yes, It Can Be Done!
It’s important to recognize that, while leverage can be asource of risk, leverage and risk aren’t the same. In fact,
when conceived not as a means of increasing market
exposure but rather as a way of extending “balance sheet”
per unit of capital, leverage can be used simultaneously to
reduce some kinds of risk and to enhance expected return.

The two preceding points are ways in which leverage canincrease the quantity of asset risk. But the application of

MARKET INSIGHTSMarch 2010 | Vol. 2 No. 1 | Page 2 of 11

Lessons from the Woodshop
Let’s consider a hypothetical fund manager with $1 million
who decides that, rather than taking an unlevered longposition in investment-grade debt that has an expectedannualized return of Libor + 1%, she will use leverage topurchase $10 million of the debt with $1 million of capital,
increasing the expected return of her investment to Libor +10% (assuming the investor funds at Libor). Although thisten-fold increase in exposure to the investment-grade debt
adds value by bringing a higher return target within reach(which is how some view the benefits of leverage), it doesn’t
improve portfolio quality as measured by the portfolio’s
expected Sharpe ratio or other risk-adjusted return metrics.
To see how leverage might be used to mitigate some risks,consider the following example. An investor wants to put$1 million to work and believes a given automobile stock is
expensive relative to its industry peers while a certain
technology stock is cheap relative to its own industry peers.
This investor is otherwise agnostic on where the overall
stock market or the auto or tech sectors in particular aregoing. Without access to leverage on the long side, the best
the investor can probably do is to short the auto stock andbuy the technology stock, capturing some of the relativevalue and hopefully hedging out most overall stock-market
risk. But with access to leverage, the investor could further
sharpen the bet by, first, hedging the short position in theauto stock with a basket of long positions in other auto
stocks and, second, hedging the long position in thetechnology stock with a basket of short positions in othertech names. The use of leverage in this second example has
two benefits: it allows the investor to isolate more precisely his
investment thesis (that the stocks are mispriced relative
to their industry groups) and focus the investment on his
precise area of expertise, which increases expected
return; and it reduces his portfolio’s exposure to industry group risk
and expected volatility.
So by using leverage, the investor has increased the
expected return of the portfolio and decreased expectedvolatility and exposure to a big risk factor (industry groupmoves) this investor has no real opinion on. This precise andcareful application of leverage is the table saw at its best.
While we’re discussing the concept of risk reduction throughcareful use of leverage, let’s discuss two hypothetical fundswith equal capital, both of which hold long and short

MARKET INSIGHTS

positions in the same set of U.S. common equities. Fund A
is 140% long and 60% short, while Fund B is 200% longand 200% short. Both funds borrow under identical terms.
We’re continually surprised at the number of market
observers who would unhesitatingly call Fund B riskier thanFund A. It’s certainly true that Fund B has a larger notional
book, and that this entails certain forms of added risk. But
in terms of overall market risk, Fund A, which is 80% net
long, is meaningfully riskier than Fund B. Fund A may also
have larger industry and sector bets, and may be lessdiversified by position given its smaller notional size. Most
counterintuitively to some observers, Fund A, despite its
smaller leverage, may well have more financing risk thanFund B because losses related to its market exposures mightin turn create financing problems. This is not to say Fund B
is less risky than Fund A. It’s just to note that the risk
analysis benefits from more than a simple comparison of raw
leverage quantity. The potentially misleading nature ofheadline leverage figures is often well understood in othercontexts. American Airlines, Ford, and Qwest
Communications, for example, all currently have a negative
leverage number, since their balance-sheet equity is
negative, despite the fact that each company has a market
capitalization of multiple billions of dollars.
Returning to the sphere of fund management, the issue, at
its core, is that people sometimes act as if risk or volatility is
proportional to the amount of leverage employed. But thisis true only if leverage is used to proportionately increase thesize of all positions instead of being used (in addition toincreasing position size) to reshape the portfolio in
potentially helpful, risk-reducing ways. If one accepts thatleverage can be both a direct source of risk and a tool
through which investors modify (by increasing or
decreasing) their exposure to other risk factors, there’s stillroom to give an account of how to think about leverage as
one of many risk factors in the portfolio construction
process. Let’s turn to that now by considering the “quality”
of a portfolio’s leverage arrangements.
The Quality of a Financing Arrangement
We believe that, although much attention is paid to thequantity of leverage employed, far too little is paid to its
quality. What determines the quality of a particularfinancing arrangement? We suggest that at least six factors
should be considered.

March 2010 | Vol. 2 No. 1 | Page 3 of 11

Lessons from the Woodshop
 Term—Longer lending commitments improve financing
quality and are especially important when financing
longer duration assets. Matching longer duration assets
with longer-term liabilities reduces the risk that financing
will be lost before the asset matures. This is particularly
the case when leveraging illiquid positions, since it
generally takes more time to obtain backup financing,and it’s more costly to sell the assets. The recent
experience of structured investment vehicles (SIVs),
which issued short-term liabilities to finance long-term
assets, is a good illustration of this point.
 Haircut/initial margin size—Other things being equal,
it’s better to have a lower “haircut” on cash instruments(or lower initial margin when entering into swaps). Thisis primarily because these forms of collateral are generally
subject to counterparty risk. A lower haircut also frees up
capital that can be put to more productive use
elsewhere.1 A haircut is similar to a down payment whenfinancing a home. A smaller down payment (and thus
higher loan-to-value ratio) generally means the buyer will
have more cash on hand for other purposes. A larger
down payment (and lower loan-to-value ratio) generallymeans the lender has mitigated more default risk.
 Haircut stability—Constant haircuts are also favored over“variable” haircuts—which allow a counterparty toincrease the haircut depending on market conditions—because the latter are most likely to be increased at
inopportune times (when capital is most precious).
Capital market lenders occasionally attempt to link
margin requirements to historical risk data, such as valueat-risk (“VaR”), on the asset being financed. Suchprovisions would effectively allow the leverage provider
to increase the margin in a crisis, which would amplify aborrower’s risk exposure and negate the benefits of term
financing by effectively forcing the borrower to refinanceat an inopportune time. Such provisions are analogous
to rating triggers that compel corporate or sovereign

1

An investment manager’s posting lower margin doesn’t necessarily mean
she’s thereby increased her leverage (and risk). Some investors confuse thehaircut with the additional cash a manager typically sets aside to support agiven position. A simple example may be helpful. Imagine that a fundmanager believes that levered asset X would prudently require total
supporting or “buffer” capital of $1 million. This is the capital that the
manager considers necessary to allow for market fluctuations and othercontingencies. If the leverage provider requires an investor to post a fixedsum (as is currently the case for credit-default swaps) of, say, $300,000,
that haircut amount should not count towards the $1 million buffer because
it’s not available for use by the manager.

MARKET INSIGHTS

borrowers to accelerate debt repayment or increase thecoupon rate when downgraded by a credit rating agency.
When rating agencies downgraded AIG in 2008, triggers
in contracts written by the insurer hastened its downfall.

 Stability of financing counterparty—It’s preferable todeal with a stable counterparty that, relative to less stableleverage providers, is (1) less likely to default, meaning
the haircut is exposed to less risk; (2) less likely to violate
contract terms or act aggressively in times of stress; and(3) more likely to be a better partner in normal market
periods and more willing to work with borrowers on newinvestment initiatives (such as capital expenditures forcorporate borrowers or new fund launches for an asset
manager).
 Valuation and other rights—A good financing
arrangement typically has a fair mechanism for pricing
the financed asset. (Recall that the 2007 implosion of
two Bear Stearns hedge funds, perhaps the mostcommonly identified initial signal of the recent credit
meltdown, was triggered by a pricing dispute, namely
one between Bear and its financing counterparties overthe value of the funds’ collateralized debt obligations.) If
a lender controls the valuation mechanism by serving as“calculation agent,” it can effectively increase the haircut
by marking an asset below fair value. If an investor
determines the valuation, he can effectively withhold
margin from the lender by marking an asset higher thanfair value. It’s common for lenders to attempt to control
the valuation process, arguing that their trading desks arein a better position to know prevailing market prices.
Some attempts at control may be more subtle thandirectly determining marks, such as provisions allowing
the calculation agent to determine whether there has
been a “market disruption event.” While these sorts ofevents may seem remote, it’s also clear they do in fact
happen from time to time, and these related provisions
could be critical in a crisis and thus constitute anunderappreciated source of correlated risk. Given theabove considerations, we generally seek margin-dispute
resolution provisions that are fair to both parties, likethird-party arbitration, and more generally try to ensurethat such fair mechanisms continue to apply in outlier
scenarios.
 Cost—Obviously, a manager should deploy borrowed
capital only if doing so increases her portfolio’s overall
utility after factoring in the borrowing cost. If an
March 2010 | Vol. 2 No. 1 | Page 4 of 11

Lessons from the Woodshop
investment manager’s utility function is simply tomaximize return, then the cost of leverage needs only tobe less than the expected return enhancement. Usually,
though, the manager would like to improve theportfolio’s return profile on a risk-adjusted basis, perhaps
as measured by its Sharpe ratio, not just (or even at all) in
absolute terms. As we’ll show below when discussing
reporting, a risk-adjusted approach to calculating the costof capital highlights the importance of assessing aportfolio’s exposures to certain risk factors in order togauge the overall riskiness of the investment.
Relatedly, although it is beyond the scope of this piece to go
into great detail, it’s worth noting that negotiating successwith counterparties in many of the areas noted above isheavily influenced by the stability of the equity capital of theborrower. For example, the more restrictive an investment
vehicle’s liquidity terms (and thus protective of the fund’s
equity capital base, especially in a meltdown situation), themore comfortable the financing provider is likely to feel inextending the term of financing or otherwise enhancing thestability of the borrowing arrangement. This relationshipdoesn’t get discussed much in the broader investmentcommunity, but is very important.
The Much Maligned Derivative: A Source ofRelatively Safe Financing

medium haircut, low cost, and having more standardized
terms and conditions. Levering a cash bond to increasecredit exposure will typically involve three-month rolling
financing; by contrast, writing (selling) a CDS on the same
name offers similar exposure without the financing risk
because, quite simply, there is no financing to lose.2 We will
have more to say about derivatives in a moment.
Managing Leverage from a Portfolio Perspective
We’ve talked thus far mostly about financing as applied
specifically to a given asset or group of assets, or as
obtained from a specific counterparty under a specific set ofterms. But let’s focus now on financing as a group of
liabilities that should be managed as a rational whole.
Modern portfolio theory has made considerable progress on
the challenge of managing a portfolio of assets, but, as
pension executives can attest, academics have historically
devoted much less attention to managing a portfolio of
liabilities. We think the latter is crucial. Fortunately, manyof the principles of managing assets also apply to managing
liabilities.

 Diversification—Diversifying liabilities reduces overall
portfolio risk. This principle applies to financing
counterparties, the types of assets being financed, andthe types of financing structures being used.
- Counterparties—It would be risky to rely on too few
counterparties because a given counterparty may
become unwilling to continue financing assets or,
worse, default. Our firm spends time considering
elements of commonality among different financing
counterparties—for example, how the counterparties
fund themselves (e.g., deposits, commercial paper,etc.)—in an effort to manage potential increases in
the correlation of the default risk of ourcounterparties.

This isn’t an especially widely held view right now, but, usedappropriately, the derivatives market is a useful store ofpotentially risk-mitigating financing tools. One reason forthe success of certain derivative products is that they embedmany of the high quality leverage features noted above,
which makes them very efficient and, believe it or not,lower-risk instruments (relative to cash equivalents) for
expressing investment views.
Consider the comparison between a corporate bond and acredit-default swap (“CDS”) on the same corporate issuer:
the financing on a cash bond is typically short term, medium
haircut, and medium cost (relative to Libor), and entails
contractual terms and conditions that are open tonegotiation. A CDS, on the other hand, has “embedded”
financing because it’s what’s referred to in the industry as an“unfunded” instrument. In this case, it means the asset isan exposure to a possible credit event that doesn’t involve
the transfer of cash other than collateral paid by the swap
client to mitigate the dealer’s counterparty risk. One could
describe this embedded financing as long term, low-to-

MARKET INSIGHTS- Asset type—By the same logic, it would be risky for
an investor to finance only a few types of assets. To
take an extreme example, suppose a fund that invests

2

In the future, a significant percentage of credit-default swaps, and possibly
other derivative contracts, may be cleared through a central clearinghouse.
In that case, the financing embedded in derivatives would be more variablebecause the clearinghouse could increase margin requirements over the lifeof a contract. Still, it’s possible that some of the same benefits ofstandardization that have resulted from futures exchanges could result incredit-default swaps retaining many of the financing benefits as comparedto levering cash bonds.

March 2010 | Vol. 2 No. 1 | Page 5 of 11

Lessons from the Woodshop
in only convertible bonds and asset-backed securities(“ABS”) obtained all of its leverage by financing its
convertible bonds. If financing counterparties
temporarily dislike convertibles for whatever reason(consider what happened to the convertible bondmarket in 2008 when regulators temporarily bannedor otherwise more tightly restricted the short selling ofcommon equities), this fund would have to scramble
to set up ABS financing arrangements. This might bea slow and difficult process, and the investor would
probably be in a weak negotiating position.

- Financing structure—It may be productive to exploit avariety of financing sources, whether explicit (such asloans) or implicit (such as various derivative contracts).
Companies often attempt to diversify their financing
by obtaining revolving credit lines, term loans, andother forms of secured and unsecured debt. In thesame way, asset managers typically look to various
financing sources—including prime brokerage, swaps,
and repurchase agreements, to name a few—to
diversify the risk of changes, whether evolutionary or
sudden, in availability of different leverage sources.
 Term structure—The term structure of a fund’s liabilities
should be managed with an eye towards the term
structure and liquidity of its assets. This principle applies
to all financial institutions. A longer, or more “termedout,” liability structure is usually more expensive thanshorter-term financing. However, as some institutions
and funds learned the hard way during the recent
financial crisis, the ultimate costs of having an inadequate
liability term structure can be enormous. One way tomodel this trade-off is to view the added cost of longerterm financing as an insurance premium for protection
against cataclysmic losses of shorter-term financing incrisis events. If a given trade is expected to be profitable
only when using inexpensive short-term financing andnot more expensive long-term financing, this may meanthat the trade’s apparent value derives purely fromfinancing or “roll” risk and thus that it’s not such a great
trade in the first place.
 Stress testing—Running stress tests on liabilities is as
important as running them on assets. One can run
liquidation scenarios of various forms: what would
happen if certain categories of financing dry up? Howmuch cash could be raised if a fund is willing to lose acertain amount by selling assets under adverse market

MARKET INSIGHTS

conditions? It can also be helpful to monitor various
static measures, such as the ratio of available cash to theamount of financing on harder-to-fund assets. The basic
intent of these stress analyses is to contemplate a variety
of awful financing climates in order to avoid taking on
too much leverage.

Reporting LeverageO

ne of the challenging aspects of leverage isdeciding how to quantify it for reporting
purposes. In our complex financial system, thishas long been a matter of debate, but the issue has taken on
greater relevance in the recent global financial crisis.
Because the crisis engulfed a variety of large financial
institutions in alarming ways, some policymakers havebroached the idea of placing limits on leverage, often fairly
uniformly across disparate categories of market activity andwithout really explaining the basis of measurement.
For example, the European Commission’s April 2009 draft
directive on Alternative Investment Fund Managers
expressed concern about any leverage level above 1x equity
capital and proposed (among other things) the imposition of
a fixed cap on the average amount of leverage employed byaffected investment management firms (while
acknowledging that such limits should vary with the type ofstrategy and firm deploying the leverage and with thesources of leverage involved). More recent debate within
the European Union has largely moved away from thenotion of strict, somewhat brute-force limits and toward
empowering regulators to monitor leverage and to impose
limits only when they perceive a significant risk to thefinancial system. Placing limits on leverage, even when
tailoring them to individual strategies or firms, presupposes
being able to measure leverage in a consistent andreasonable fashion.
Although there’s been much discussion lately among
regulators, accounting standards boards, and industry
associations about how best to measure leverage, there’s
still no consensus, and different measurement methods canresult in very different outcomes. Investment management
firms, too, are engaged in a form of implicit debate on this
topic by virtue of the different methodologies they employ
when reporting leverage levels to investors or creditors. In
our opinion, too many investment managers have adopted
approaches to measuring and reporting leverage thatmeaningfully understate or otherwise obscure the actual
March 2010 | Vol. 2 No. 1 | Page 6 of 11

Lessons from the Woodshop
leverage of their portfolios. At the same time, investors andtheir consultants often unwittingly compare one hedge
fund’s leverage “apples” to another fund’s leverage“oranges.” The treatment of derivatives for purposes ofleverage reporting is a case in point.
Context Matters When Calculating Leverage
As noted earlier, we believe that, from a portfolio management
standpoint, certain derivatives may offer advantages because
they are unfunded instruments. High quality leverage, though,isn’t the same as no leverage at all, even if some measures ofleverage might suggest otherwise. Under U.S. generally
accepted accounting principles (U.S. GAAP), the notional
exposure of certain derivative contracts is not recognized on
the balance sheet. If leverage is measured simply in terms ofbalance sheet assets, then derivative exposure may not bemeaningfully factored into leverage calculations.
Consider the differences between funding a cash instrument
and an unfunded derivative. For example, writing a CDS for$10 million notional on a corporate credit offers economic
exposure roughly similar to buying $10 million of the same
issuer’s cash bond with financing. The swap’s notional
exposure would be off-balance sheet under U.S. GAAP. On
the other hand, if the investor purchases $10 million of thecredit on traditional prime brokerage margin, the asset andliability would appear on the balance sheet and thus increase
the balance-sheet leverage of the portfolio. A fundmanager may therefore find it doubly expedient to report toinvestors solely on the basis of U.S. GAAP balance-sheet
leverage because the leverage calculation is relatively
uncomplicated and the output downplays (possibly a lot) theamount of leverage actually employed.
Although there are clearly some limitations associated withthis balance-sheet approach, it’s also important to recognize
how alternative approaches that factor derivative exposure
into leverage calculations (let’s call these alternative methods“derivative-adjusted leverage” for convenience) can create
their own problems. For one thing, derivative-adjusted
leverage figures don’t indicate how much financing a fund isusing. A 4x derivative-adjusted leverage number doesn’tnecessarily mean that a fund is borrowing 3x its equity capital.
It’s possible that the 4x figure stems from exposure to
unfunded derivatives, and therefore the fund is not actually“borrowing” much money at all. Also, certain derivatives
may balloon headline leverage numbers even though the
instruments in question don’t meaningfully increase portfolio

MARKET INSIGHTS

risk or create any additional financing risk. Consider a pairtrade in which a fund takes a $1 billion long position in an
investment-grade credit index and a $1 billion short position
in a nearly identical index, and the maximum loss is $20
million. Even though the maximum loss is relatively small, theadditional $1 billion on the long side would greatly expand
the fund’s long derivative-adjusted leverage number. The
same is true of interest-rate swaps: their notional values, andthus the nominal leverage, are large relative to the amount ofrisk involved.
Another example of how context matters is the location ofleverage. For example, Fund A invests in distressedcompanies that may be levered only 1x at the fund level, but
the underlying investments may be levered 10x at thecompany level. By comparison, Fund B invests in investmentgrade debt that is levered 2x at the company level and applies
5x leverage at the fund level. Although the leverage is nonrecourse to external investors in both funds, for Fund A the
preponderance of the leverage is non-recourse to the fund as
well, which is not true of Fund B. But the overall market risk
and leverage of each fund are essentially equivalent despite
the radically different headline leverage numbers; the majordifference is simply where the leverage is applied.
Transparency through Multiple Leverage Figures
We’ve devoted considerable thought to the reporting ofleverage. Simply put, we believe more information is better:different metrics can help make sense of the nuances
surrounding the measurement of leverage levels. This is why
we think it’s generally most appropriate to use at least both of
the broad calculation methods (balance-sheet leverage andderivative-adjusted leverage) outlined above.
In that respect, we believe that drawing conclusions about therisk profile or other characteristics of investments by comparing
raw aggregate leverage figures is at best incomplete and atworst highly misleading. Gauging the impact of leverage on afund (or one of its underlying investments) requires a deeper
and more nuanced understanding of how leverage could
interact with a number of risks, including market directionality,
concentration, illiquidity, value/growth style biases,
capitalization, subordination, and other factors. Just as we
believe it would be unwise to evaluate a fund on the basis of asingle measure of aggregate risk (whether it be VaR, historicalvolatility, downside deviation, or similar metrics) independentlyof its exposures to the common risk factors cited above, we
believe that evaluating leverage using a single number,March 2010 | Vol. 2 No. 1 | Page 7 of 11

Lessons from the Woodshop
whether comparatively or in isolation, offers insufficient insight
into the potential implications of the leverage applied.

Using the three leverage metrics above and assuming no
PnL, such a fund would exhibit the following exposures:

In keeping with these views, we believe the following leverage
metrics can be helpful in considering the leverage of a given
investment vehicle:

 Long derivative-adjusted leverage:

5x Net derivative-adjusted leverage:0x Balance-sheet leverage:

3x Long derivative-adjusted leverage—long market value ofcash and derivative instruments divided by total
investment vehicle capital; Net derivative-adjusted leverage—net market value(absolute value of the amount that results from netting
all long and short market values) divided by total
investment vehicle capital; and Balance-sheet leverage—U.S. GAAP balance-sheet assets
divided by total investment vehicle capital.
Reporting multiple figures is consistent with our earlier
discussion about understanding the trade-off between
opportunity and risk because multiple leverage calculations
can help illuminate underlying exposures. Although longand net derivative-adjusted leverage convey important
information about the risk-profile of specific investment
strategies, the juxtaposition of these figures with theaggregate balance-sheet leverage of an investment vehicle
offers some important insights into how efficiently thatvehicle is deploying its capital, its exposure to the stability
and creditworthiness of its financing counterparties, and thepotential for leverage to amplify risks to which the portfolio
may already be exposed.
To illustrate these points, consider a fund deploying a simple
long/short credit strategy with a total of $100 million of
investor capital and access to prime broker leverage and theswap market. (For convenience, we’ll ignore the issue of
buffer capital.) The fund invests $60 million in cash bonds.
 Using the bonds as collateral for prime broker financing,it obtains a total of $300 million in long exposure to cash
instruments (including the $60 million above).
 The fund also posts $40 million as initial margin whenwriting CDS contracts to secure another $200 million inlong exposure.
 The fund seeks to hedge its long exposure by entering
into CDS that provide $500 million of short exposure.

MARKET INSIGHTS

Inclusion of long derivative-adjusted leverage in thisfund’s reporting affords important transparency about theleverage level employed. First, it’s important thatinvestors understand the magnitude of a vehicle’s longexposure. For example, although long and short
exposures may track each other relatively tightly undernormal market conditions, that may not be the case whenmarkets enter periods of stress. The potential for such“basis risk” (see Market Insights vol. 1, no. 1) within
specific asset classes highlights the importance ofunderstanding derivative-adjusted leverage. This method
offers investors a nice comparative baseline for evaluating
the risk profile of different funds or strategies.
Second, the combination of the long derivative-adjusted
and balance-sheet leverage figures provides some insight
into the degree of stability associated with the leverage.
In the simple example above, the fund borrows $240
million from the prime broker, meaning that less than halfof the portfolio’s long market value is exposed to funding
risk because there is no potential loss of borrowed funds
on the CDS. The U.S. GAAP balance-sheet leverage
figure indicates that the fund is borrowing closer to 2x its
total capital rather than the 4x implied by the longderivative-adjusted figure. Finally, as we have seen, a 5x
leverage figure should be viewed in light of a vehicle’s
overall exposure to market risk and in particular its
exposures to risk factors that are common to manymarket participants. The above fund’s 5x derivativeadjusted leverage may seem high relative to anotherfund’s 2x derivative-adjusted leverage, but if the net
derivative-adjusted leverage for the second fund is 1x andthat is associated with a large directional market exposure,it’s not clear that the above fund presents more risk.
Having seen how context matters when interpreting themeaning of leverage figures, we attempt to adjust for
distortions that may arise when factoring derivative
exposures into our reporting. Interest-rate swaps, forexample, typically involve large notional exposuresrelative to the risk that is taken on by the investor. When
March 2010 | Vol. 2 No. 1 | Page 8 of 11

Lessons from the Woodshop
calculating our leverage figures, we convert interest-rate
swaps to 10-year bond-equivalents and net those
exposures off against instruments with similar maturities
but opposite exposures.3 We do so because interest-rate
swaps don’t reference underlying cash instruments, andtheir notional values aren’t tied to the market value of anequivalent asset. Including the notional values ofinterest-rate swaps when calculating the long or shortmarket value of a portfolio would typically dwarf theleverage of other strategies in that portfolio. Combining
the disproportionately larger gross market values of
instruments with low sensitivities to market movementswith instruments having smaller notional values but
relatively higher sensitivities to market movements (suchas total return swaps on non-G3 sovereign debt) mightlead an investor to assign much higher effective leverageto the second set of instruments and thereby distort the“true” leverage of the strategies employing them.

 focus on longer-term financing sources in an effort tomaintain the flexibility to manage assets in occasional
stressful scenarios, even if this costs more in the shortterm;
 diversify both assets and liabilities to enhance the risk
profile of portfolios and to obtain better, more stableleverage terms than less diversified pools of capital, in
keeping with the multi-disciplinary approach to investing
we tend to prefer; take advantage of aggregate assets under management
to develop strong relationships with financing
counterparties and pursue arrangements that have morebalanced terms than would otherwise be available; and be diligent in negotiating financing arrangements andreviewing the governing documents, both when initiating
those arrangements and over time.

The foregoing illustrations consider single snapshots intime. But given the limitations and complexities
associated with calculating leverage, we believe it’s also
important that investors consider how these leverage
figures change over time. Trend analysis, whether acrossdifferent funds or underlying strategies, can shed light on
how leverage levels may change as market conditions shift.

We believe that the inherent complexity of leverage places apremium on transparently reported, multiple measures ofleverage. We believe that investors will be well served bysubjecting the leverage figures reported by asset managers
to critical scrutiny, including evaluating leverage figures overmultiple periods and across multiple vehicles and strategies
using consistent measurement tools.

Conclusion

We’re regularly surprised by the degree of importance thatis attached to unadjusted balance-sheet leverage numbers to
the seeming exclusion of other risk considerations. Ifhypothetical Fund A reports an aggregate balance-sheet
leverage of 3x and Fund B an aggregate leverage of 2x, it
may well be the case that Fund A is more highly levered
than B. But it’s also sometimes true in our experience that
Fund A in this example is, when viewed through otherlenses like derivative-adjusted leverage, in fact less levered,or more solidly funded, or less exposed to market risk, thanFund B. Investors will sometimes look only at unadjusted
headline leverage numbers and opt for what’s perceived as
the “lower” leverage investment, even when thatinvestment actually is more highly levered or otherwise
riskier. And in the case where the 3x and 2x figures forFund A and Fund B are computed using very different
methodologies, a comparison between the two can berendered even more specious.

Over our more than twenty-year history, we
believe we’ve amassed considerable experienceand learned important lessons (sometimes atmeaningful cost) in managing leverage as we seek toenhance our risk-adjusted investment results. We recall thatthe school woodshop teacher with the missing pinky was
not only good at using the machine saw, but maybe also a
bit more respectful of its dangers than newer practitioners
with a full complement of digits. Here are a few key
principles that we’ve attempted to follow in managing ourliabilities:

3

Such “netting” rules will be familiar to those versed in the comparative
treatment of derivatives under U.S. GAAP and International Financial
Reporting Standards (“IFRS”). U.S. GAAP has more liberal rules than IFRS
regarding the netting of exposures to various over-the-counter derivatives
and repurchase agreements. As a result, financial institutions adhering to IFRS
typically report higher leverage figures than those relying on U.S. GAAP.

MARKET INSIGHTS

We’ve hopefully demonstrated that quantity should not be
the sole consideration in evaluating leverage. Equallyimportant are the quality and riskiness of both the portfolio
March 2010 | Vol. 2 No. 1 | Page 9 of 11

Lessons from the Woodshop
and the leverage supplied. One should closely analyze theinterplay among a portfolio’s concentration and liquidity, theexpected duration of its assets, the average term of theleverage, the stability of leverage providers, and otherfactors. We believe managers and investors would mutually
benefit from more comprehensive dialogue around thesubject of leverage, even though this unavoidably means a
bit more complexity in those discussions. In time, we hope
those discussions will be facilitated by an increasingly sharedvernacular regarding the management and measurement ofleverage.

MARKET INSIGHTSMarch 2010 | Vol. 2 No. 1 | Page 10 of 11

Lessons from the Woodshop
The views expressed in this commentary are solely those of
the D. E. Shaw group as of the date of this commentary.
The views expressed in this commentary are subject tochange without notice, and may not reflect the criteria
employed by any company in the D. E. Shaw group toevaluate investments or investment strategies. This
commentary is provided to you for informational purposes
only. This commentary does not and is not intended toconstitute investment advice, nor does it constitute an offer
to sell or provide or a solicitation of an offer to buy any
security, investment product, or service. This commentary
does not take into account any particular investor’s
investment objectives or tolerance for risk. The information
contained in this commentary is presented solely withrespect to the date of this commentary, or as of such earlier
date specified in this commentary, and may be changed or
updated at any time without notice to any of the recipientsof this commentary (whether or not some other recipients
receive changes or updates to the information in thiscommentary).
No assurances can be made that any aims, assumptions,
expectations, and/or objectives described in thiscommentary would be realized or that the investment
strategies described in this commentary would meet theirobjectives. None of the companies in the D. E. Shaw group;
nor their affiliates; nor any shareholders, partners,
members, managers, directors, principals, personnel,
trustees, or agents of any of the foregoing shall be liable forany errors (to the fullest extent permitted by law and in theabsence of willful misconduct) in the information, beliefs,
and/or opinions included in this commentary, or for theconsequences of relying on such information, beliefs,
and/or opinions.

MARKET INSIGHTSMarch 2010 | Vol. 2 No. 1 | Page 11 of 11