Monday, April 6, 2009

MM homemade leverage and hedge funds

Students of corporate finance should remember learning about homemade leverage and the Modigliani and Miller theory of capital structure irrelevance. In a nut shell (absent taxes and bankruptcy costs), leverage doesn't matter. This is because an investor can lever up or de-lever a position to attain his or her own desired level of leverage.

Hedge funds make bets on securities and also lever up. On Portfolio.com there is a nice posting talking about why hedge fund managers shouldn't use leverage, and why hedge fund investors should choose the level of leverage that they desire.

It's a nice example of an application of capital structure irrelevance.