The Limits of Leverage
32 Pages Posted: 7 Jun 2014 Last revised: 11 Sep 2016
Date Written: September 10, 2016
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 return 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.
Keywords: leverage, transaction costs, portfolio choice, performance evaluation
JEL Classification: G11, G12
Suggested Citation: Suggested Citation