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Leverage, liquidity, volatility, time horizon, and the risk of ruin

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  • Erik Norland
  • D.Sykes Wilford

Abstract

In order to meet their financial goals, investors, whether institutions or individuals, must make asset allocation decisions by balancing their return targets with their tolerance for volatility, their liquidity requirements, and time horizons. Yet even optimal mixes of investments with regard to time horizon, liquidity, and volatility levels are sometimes not adequate to achieve the return objectives of a firm or an individual. Using leverage scales up both returns and risks, introducing the potential for default. When using leverage, either as a fund manager or as an investor into a fund, fully understanding the potential for default is absolutely necessary. Using standard measures of risk and return can be very misleading. Sharpe ratios and information ratios can lead the investor into a state of unwarranted comfort with respect to the probability of losing more than is acceptable. Many traditional measures of risk do not deal with this problem correctly. This paper takes a barrier option theoretic approach to analyzing the potential for losses and the potential for the leveraged investor to be knocked‐out of his position even under circumstances of perfect knowledge of the end return. Thus, it demonstrates the necessity of a more rigorous approach to understanding the risk of any particular style of investment, particularly when dealing with hedge funds.

Suggested Citation

  • Erik Norland & D.Sykes Wilford, 2002. "Leverage, liquidity, volatility, time horizon, and the risk of ruin," Review of Financial Economics, John Wiley & Sons, vol. 11(3), pages 225-239.
    • Handle: RePEc:wly:revfec:v:11:y:2002:i:3:p:225-239
    DOI: 10.1016/S1058-3300(02)00046-0
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    References listed on IDEAS

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    1. P. Carr, 1995. "Two extensions to barrier option valuation," Applied Mathematical Finance, Taylor & Francis Journals, vol. 2(3), pages 173-209.
    2. Naoto Kunitomo & Masayuki Ikeda, 1992. "Pricing Options With Curved Boundaries1," Mathematical Finance, Wiley Blackwell, vol. 2(4), pages 275-298, October.
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