It is possible to calculate leverage...
6.2 It is possible to calculate leverage by adding the long positions to the short positions (treating both as positive values) and dividing by the capital. This result of 2.25:1 ($40 million plus $50 million ч $40 million) is reasonable. Frequently, the leverage will be calculated from the assets on the balance sheet and the liabilities will be ignored. Using this methodology, the leverage is 2.5:1 ($40 million + $60 million ч $40 million).
The $60 million serves as a proxy for the short positions, because it represents the collateral posted to borrow the stocks held short. The fund has $10 million tied up in haircuts on the short positions. 6.3 A hedge fund probably would not want to buy the asset. It would expect to lose money borrowing at 5 percent to invest in the security expected to earn 3 percent. In fact, the fund probably shouldn't buy the asset at all (without leverage) because any unused capital could earn a higher return as a short-term investment earning 5 percent.
The fund might buy the asset anyway if it is part of a strategy that is expected to make money overall (a basket trade, for example). A manager might buy the asset despite the expected loss if the security improved the characteristics of the portfolio (the risk of loss, favorable cash flow, favorable tax treatment, or other factors). The fund might want to sell the asset short, however. The fund could expect to lose 3 percent on the security held short but could invest the proceeds of the sale at 5 percent. Whether the trade was profitable would depend on the haircut required and execution costs. The manager should also assess whether a short position in the security would increase or reduce risk to the portfolio.
6.4 The first fund can be described as unlevered. This means the fund has leverage of 1:1. The second fund has leverage of 1:1 only if it can borrow the securities to cover its short without having to put up a haircut. If the fund has to post margin, the leverage of the fund containing the short positions would exceed 1:1 if the leverage ratio is calculated from the asset side of the balance sheet, as is the convention.