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The limits of leverage

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  • Paolo Guasoni
  • Eberhard Mayerhofer

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.

Suggested Citation

  • Paolo Guasoni & Eberhard Mayerhofer, 2019. "The limits of leverage," Mathematical Finance, Wiley Blackwell, vol. 29(1), pages 249-284, January.
    • Handle: RePEc:bla:mathfi:v:29:y:2019:i:1:p:249-284
    DOI: 10.1111/mafi.12172
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