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I think that I understand how leverage works if one had a long strategy in equities and had some (roughly) fixed market value invested over time.

Suppose that an investor has 10 million invested in the above strategy. Then 2 times leverage means that the strategy runner borrowed 10 mill and also used it on the strategy so that the strategy is actually invested with 20 million rather than 10 million.

This way, from an investor standpoint, the overall return to the investor doubles when the raw overall return is positive. So, if the strategy returned 3 percent raw return, then the investor actually gets a 6 percent return on his investment aside from funding costs.

By this we mean that the rate that the extra 10 million was being borrowed at which has to be subtracted out of overall PNL.

Assuming above is correct,(It could very well not be), then how does leverage work when one has a long short strategy that isn't necessarily dollar neutral but is always flat at the end of the day.

One one day, the long side could be greater than the short side for most of the day, on another day the opposite could be the case. Also, the amount long and the amount short on any particular day is not fixed at some dollar value. This is because positions are not carried overnight. Does it still work that, if you do 2 times leverage then you're overall return to the investor doubles when it's positive.

Of course the costs have to be taken into account but what are these costs ? In other words, do you just take the absolute value of the market value of short side and add that to the market value of the long side in order to calculate the cost of funding ? I don't get it because the short side doesn't have to be funded because you're receiving capital when you short so you don't need as much funding on the short side. It generates its own funding. But I might not be understanding the whole concept of leverage. Thanks.

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PnL = (MV longs - Cost longs) + (Cost shorts - MV shorts) - (Funding Costs)

Funding Costs = Borrowing Costs for Long Position - Rebate (if any for lending your long securities) + Stock loan fees (paid to borrow stock) - Interest earned on Cash balances

Cash balances = Beginning Cash - Purchases + Proceeds from Shorts

% Return = PnL / Capital (or AUM)

In calculating your leverage ratio for a long short fund:

Gross Leverage = (MV of longs + MV of Shorts) / Capital (or AUM)

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  • $\begingroup$ @AIRacoon: Thanks. I'll go over carefully and hopefully understand. $\endgroup$ – mark leeds Sep 21 '20 at 15:29

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