When evaluating the use of leverage in a portfolio, which statements are true?

• A. Leverage magnifies gains and losses, increases volatility and drawdown risk; requires strict risk controls, stress testing, and clear exit rules
• B. Leverage reduces risk and volatility
• C. Leverage has no effect on drawdown
• D. Leverage guarantees higher returns without additional risk

Answer: (A)

Understanding how leverage affects portfolio risk and return. Using leverage means borrowing funds or using derivatives to increase exposure, so movements in asset prices are amplified. This magnifies both gains and losses, which raises portfolio volatility and can deepen drawdowns from peak values. Because of that increased risk, strict risk controls are essential: careful position sizing, a clear maximum leverage framework, thorough stress testing for adverse scenarios, and explicit exit rules to cap losses and protect liquidity. In short, leverage changes the risk-return trade-off by magnifying outcomes and requiring disciplined risk management, not reducing risk, not eliminating drawdown, and not guaranteeing higher returns without additional risk.