The limits of leverage

Paolo Guasoni, Eberhard Mayerhofer

Research output: Contribution to journalArticlepeer-review

Abstract

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.

Original languageEnglish
Pages (from-to)249-284
Number of pages36
JournalMathematical Finance
Volume29
Issue number1
DOIs
Publication statusPublished - Jan 2019

Keywords

  • leverage
  • portfolio choice
  • transaction costs

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