How Does Leverage Amplify Both Gains and Losses for a Hedge Fund Selling CDS?

Leverage involves using borrowed capital to increase the size of a position beyond what would be possible with the fund's own money. When a hedge fund sells a CDS, it receives premiums on a large notional amount while posting only a fraction of that amount as collateral.

If no credit event occurs, the return on the fund's actual capital is greatly magnified. However, if a credit event does occur, the fund is liable for the full notional amount, and the losses on its invested capital can be catastrophic, potentially exceeding the initial investment.