TY - JOUR
T1 - The limits of leverage
AU - Guasoni, Paolo
AU - Mayerhofer, Eberhard
N1 - Publisher Copyright:
© 2018 Wiley Periodicals, Inc.
PY - 2019/1
Y1 - 2019/1
N2 - 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.
AB - 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.
KW - leverage
KW - portfolio choice
KW - transaction costs
UR - http://www.scopus.com/inward/record.url?scp=85041685809&partnerID=8YFLogxK
U2 - 10.1111/mafi.12172
DO - 10.1111/mafi.12172
M3 - Article
AN - SCOPUS:85041685809
SN - 0960-1627
VL - 29
SP - 249
EP - 284
JO - Mathematical Finance
JF - Mathematical Finance
IS - 1
ER -