Theory of Leveraged Portfolio Selection Under Liquidity Risk

45 Pages Posted: 8 Jan 2021

See all articles by Chanaka Edirisinghe

Chanaka Edirisinghe

Rensselaer Polytechnic Institute (RPI) - Lally School of Management & Technology

Jingnan Chen

School of Economics and Management, Beihang University

Jaehwan Jeong

Radford University

Date Written: July 4, 2020

Abstract

We study the impact of liquidity in optimal portfolio choice under leveraging to improve risk-adjusted and absolute returns. We consider a quasi-elastic market with continuous trading where temporary liquidity costs are sufficiently large relative to permanent impact. We show analytically that the Sharpe-maximizing unlevered portfolio is no longer a tangency portfolio. As target mean increases, required portfolio-leverage increases at an increasing-rate, while Sharpe-Leverage frontiers are progressively-dominated. Moreover, security-market relationships are no-longer linear and the usual proportionate-leveraging is not an optimal strategy. We develop insights for choosing return targets for leverage-constrained investors, and provide computational analyses to highlight the analytical findings.

Keywords: Portfolio optimization, liquidity risk, trading impact on price, portfolio leverage, risk-adjusted returns

JEL Classification: C44, C68, G11, G12

Suggested Citation

Edirisinghe, Chanaka and Chen, Jingnan and Jeong, Jaehwan, Theory of Leveraged Portfolio Selection Under Liquidity Risk (July 4, 2020). Available at SSRN: https://ssrn.com/abstract=3730627 or http://dx.doi.org/10.2139/ssrn.3730627

Chanaka Edirisinghe (Contact Author)

Rensselaer Polytechnic Institute (RPI) - Lally School of Management & Technology ( email )

110 8th St
Troy, NY 12180
United States

Jingnan Chen

School of Economics and Management, Beihang University ( email )

Xueyuan Road, Haidian District
Beijing, 100191
China

Jaehwan Jeong

Radford University ( email )

PO Box 6916
Radford, VA 24142
United States

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