[rmrfstar]

Also, a lot of people make 10x levered bets on AAA instruments, which means even a 10% loss can wipe you out.

The trick is "repo", or repurchase agreements.

(1) Buy bonds

(2) Use those bonds as collateral for a low-interest loan

(3) Use the loan money to buy bonds

(4) goto 2

See, e.g [1]

[1] https://www.bloomberg.com/news/articles/2020-04-15/how-repo-...

[dia80]

The "haircut" on risky assets stops you leveraging it too much. I think it's about 5% for US treasury bonds. So for every 100 I want to finance I need to have 5 cash on hand. Itsuch higher for riskier assets and that keeps leverage down. Also when things start to get edgy banks demand a bigger haircut further reducing the available leverage forcing you to delever (e.g. March)

[rmrfstar]

If you step through the arithmetic, you see that a 5% haircut can take you to 20x leverage. It's a geometric series.

That means that investors' internal risk limits are the binding constraint, not repo haircuts.

It's another way of saying that the financial sector sets its own leverage. Historically, that has not turned out well. It's why Dodd-Frank included a leverage rule for large banks.

[whatok]

> That means that investors' internal risk limits are the binding constraint, not repo haircuts.

While part of risk, expected return is a larger binding constraint in most cases over risk limits. I'm probably not going to lever up 20x for an tiny expected return. On the other hand, I may very well lever up 5-10x on something 50x more risky than treasuries if the 10yr is yielding 0.725%.

[rmrfstar]

In practice most PM's have a VaR limit and a battery of dollar exposure limits, which are all set by the risk department.

There is some credible research which suggests that large financial institutions act as if they are optimizing mean return subject to a VaR constraint [1].

[1] https://www.nber.org/papers/w18943

[whatok]

VaR is a fake number for way too many reasons to get into and anyone who paid attention to VaR these past few months would have lost a ridiculous amount of money. I only have experience working for hedge funds and how risk is managed greatly differs from fund/strategy/assets traded. Banks no doubt manage to VaR but banks also supposedly don't have prop trading desks anymore so they function much differently now.

[rmrfstar]

The discussion seems to have shifted to argument for argument's sake.

But for the sake of argument: large bank VaR models affect hedge funds because hedge funds get their leverage through their prime brokers which are... large investment banks.

[karatestomp]

Aha. Is this how folks actually attain worthwhile rates of return on very low-return, low-risk investments?

[EDIT] well no that can't be it because it requires even more money coming in for those loans, which can't provide more expected return than the bonds they're buying or the whole thing would be pointless.