The limits of leverage

When trading incurs proportional costs, leverage can scale an asset's return only up to a maximum multiple, which is sensitive to its volatility and liquidity. In a model with one safe and one risky asset, with constant investment opportunities and proportional costs, we find strategies that ma...

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Bibliographic Details
Published inMathematical finance Vol. 29; no. 1; pp. 249 - 284
Main Authors Guasoni, Paolo, Mayerhofer, Eberhard
Format Journal Article
LanguageEnglish
Published Oxford Blackwell Publishing Ltd 01.01.2019
Subjects
Assets
Costs
Leverage
portfolio choice
Trading
transaction costs
Volatility
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Summary:When trading incurs proportional costs, leverage can scale an asset's return only up to a maximum multiple, which is sensitive to its volatility and liquidity. In a model with one safe and one risky asset, with constant investment opportunities and proportional costs, we find strategies that maximize long‐term returns given average volatility. As leverage increases, rising rebalancing costs imply declining Sharpe ratios. Beyond a critical level, even returns decline. Holding the Sharpe ratio constant, higher asset volatility leads to superior returns through lower costs.
ISSN:0960-1627
1467-9965
DOI:10.1111/mafi.12172