Financing and Margin Cost Modeling

Running a strategy at 2x leverage in a spreadsheet is one keystroke: multiply the return series by two. Running it at 2x leverage in a real account means borrowing an amount equal to the account's own equity, and that borrowed cash costs interest — margin interest from a broker, or repo financing from a prime broker, depending on the setup. A backtest that applies the leverage multiplier to returns but not to the financing side is describing a strategy that borrows money for free, which is not a strategy anyone can actually run.

Worked example: the levered strategy that gives half its edge to the lender

An unlevered long strategy earns 8% a year with 10% volatility, a Sharpe of about 0.8 assuming zero risk-free rate. Levering it 2x is attractive because it doubles the return and the volatility, keeping the Sharpe the same — in theory.

	Unlevered	2x levered, no financing cost	2x levered, with financing
Asset return	8%	16%	16%
Financing cost on borrowed leg (5.5%, borrowed = 1x equity)	—	—	−5.5%
Net return	8%	16%	10.5%
Volatility	10%	20%	20%
Sharpe	0.80	0.80	0.53

The naive doubling shows a levered Sharpe identical to the unlevered one — leverage looks like a free scaling knob. Once the actual cost of the borrowed capital is subtracted, the levered Sharpe drops by a third, because volatility scaled perfectly with leverage but return did not — the financing cost is a fixed drag that doesn't grow with market exposure the way the borrowed capital's return does.

The correction is mechanical: track borrowed notional day by day, apply the period's actual financing rate to it, and subtract that carry from gross P&L before computing any leverage-adjusted Sharpe or drawdown figure.