leveraged (2x, 3x) index funds. How do they work?
In: Economics
Seeing a lot of comments here either getting the details wrong or omitting them. More often than not the fund enters into a contract called a Total Return Swap (TRS) with a bank’s prime brokerage division. The TRS gives the fund exposure to $X notional of some underlying asset. In return, the fund pays Y% interest on that notional exposure, to compensate the bank for A) The bank’s funding costs for buying the underlying asset and holding it on their balance sheet, and B) A (usually smallish) profit margin. X can be basically any amount, but the prime brokerage will usually have some additional margin requirements that scale with notional exposure so that, for a move in the underlying consistent with its historical volatility, adjusted for the credit quality of the fund, there will be enough money sitting in the margin account to make sure the bank gets paid if the position moves against the fund.
This sometimes doesn’t work out, and that’s how Credit Suisse lost a billion dollars when Archegos failed.
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