Analysing The Optimal Level of Leverage

A thesis submitted for the degree of
PhD in Computational Finance
Analysing the optimal level of leverage in stock

markets using numerical methods and
agent-based modelling
Elton Felipe Sbruzzi
Thesis Advisor
Dr. Steve Phelps
Centre for Computational Finance and Economic Agents (CCFEA)

School of Computer Science and Electronic Engineering
University of Essex
November 2012
Declaration
I hereby declare that this thesis is my own work, and has not been submitted for
the award of a higher degree elsewhere. Where other sources of information have
been used, they have been acknowledged.
The work in this thesis has contributed to the following publications:
Sbruzzi, E. and S. Phelps: 2011. Optimal Level of Leverage using Numerical
Methods. In, 7th Conference of the Portuguese Finance Network, Aveiro,
Portugal.
Sbruzzi, E. and S. Phelps: 2013. Testing leverage-based trading strategies
under an adaptive-expectations agent-based model. In, 12th International
Conference on Autonomous Agents and Multiagent Systems (AAMAS 2013).
Elton Felipe Sbruzzi

November 2012
Abstract
Leverage offers the possibility of enhancing financial returns and, consequently, the
profit and the end of period wealth. Leverage is gaining importance and has been
widely adopted in the financial markets for two reasons. Firstly, brokers are interested in offering margins because they can charge higher transaction fees and
make profits from lending margins. Secondly, investors are also interested in taking
leverage because of the ability to enhance their individual returns. The motivation
of this thesis is that, even though leverage is gaining importance in modern investments, existing models in the literature models assume that the series of financial
returns are normally distributed. However, financial returns present high-level of
kurtosis and, hence, are not normally distributed. Thus, existing analytical models
underestimate extreme returns and consequently underestimate the risk of default.
I contribute to this field by proposing a new trading strategy that uses numerical
methods to calculate the optimal level of leverage instead of the existing analytical
models. The use of numerical methods allows me to relax the assumption of normally distributed returns, and hence minimises the risk of underestimate extreme
returns and the risk of default. I investigate whether the use of numerical methods leads to a more accurate optimal level of leverage than analytical models, and
if the use of the optimal level of leverage using numerical methods improves the
investment performance. In order to test the ability of the optimal level of leverage using numerical methods to improve the investment performance, I employ two
different approaches: back-testing and agent-based modelling. Back-testing allows
me to test the optimal level of leverage using numerical methods using empirical
evidence, and agent-based modelling allows me to test the optimal level of leverage
using numerical methods in a totally controlled environment. The conclusions are
that the use of numerical methods leads to a more accurate optimal level of leverage
than analytical models; using daily historical data as an empirical evidence, the optimal level of leverage using numerical methods improves investment performance;
and in a totally controlled environment, the ability of the optimal level of leverage
to improve investment performance depends on the size of the market.
Acknowledgments
Writing a thesis and getting a PhD is a life-changing opportunity. It requires the full
dedication of the candidate and the support of every one who is part of his life. For
this reason, I would like to express my gratitude to a number of people. Without
their help, support and patience, certainly this work could not have been done.
Firstly, I would like to thank the group of the most important people of my life,
my family; my parents, Mr. Arnaldo Felipe Sbruzzi and Mrs. Luciana de Souza
Sbruzzi; my wife, Mrs. Ana Paula Ribeiro Duarte Sbruzzi; and my son, the reason of
my life, who was born during the PhD period, Lus Felipe Duarte Sbruzzi. Without
them, nothing here would make much sense and I would not be able to reach any of
my objectives. They are unique for me and their love and support makes me strong
to reach my dreams.
Secondly, I would like to thank my supervisor Dr. Steve Phelps. His patience
with me was impressive. He provided me with an appropriate and supportive environment that allowed me to go further in my research. He offered me the chance
to express my ideas without fear of reprisal. He helped me to limit the scope of my
research and was receptive to correct the natural mistakes that I have made during
the research.
Thirdly, I would like to thank Mr. Davi Baccan. Mr. Baccan is a closed friend
and he has been pursuing a PhD in Computer Science at the University of Coimbra,
Portugal. Mr. Baccan has provided me with every necessary informal support in
many area of the research.
Fourthly, I would like to thank Cynthia Rocha. With her support, I could review
and improve my writing, in a much clear and sophisticated fashion.

Fifthly, I would like to thank the Sfera Stock Analysis clients. It is the business
of my family, and this has more than 38k clients. The business funded my PhD
studies and my stay in the UK.
Sixthly, I would like to thank the staff of the Centre for Computational Finance
and Economic Agents of University of Essex. They have offered me every support that I have required and have provided me the sufficient infra-structure to do
my research. I had the opportunity to attend some important mini-courses in the
university which facilitated the research.
Finally, I would like to thank the University of Essex community and all my
friends from Colchester and in the UK. If I name each of them, certainly dozens of
pages would be necessary. Furthermore, there would be a risk of forgetting someone.
However, each one is very special and made my PhD experience more exciting and
amazing than I could have expected.
Contents
List of Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
List of Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 1: Introduction . . . . . . . . . .
1.1 Motivation . . . . . . . . . . . . . . .
1.2 Research Objectives . . . . . . . . . .
1.3 Summary of Research Contributions
1.4 Overview and Structure . . . . . . .
1.5 Publications . . . . . . . . . . . . . .
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Chapter 2: Literature Review . . . . . . . . . . . . . . .

2.1 Leverage . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 Return Estimation . . . . . . . . . . . . . . . . . . .
2.3 Investors Objective Function . . . . . . . . . . . . .
2.4 Geometric Mean, Leverage and End of Period Return
2.4.1 Single Period Equity Return . . . . . . . . . .
2.4.2 Geometric Mean and End of Period Return .
2.5 Optimal Leverage Models . . . . . . . . . . . . . . .
2.5.1 The Kelly Criterion . . . . . . . . . . . . . . .
2.5.2 The Rotando and Thorp Model . . . . . . . .
2.5.3 Geometric Brownian Motion . . . . . . . . . .
2.6 Agent-Based Modelling . . . . . . . . . . . . . . . . .
2.7 Summary . . . . . . . . . . . . . . . . . . . . . . . .
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Mean on Leverage
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Chapter 4: Optimal Level of Leverage using Numerical Methods

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.2 Numerical Methods . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3 Experiment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3.1 Methodology . . . . . . . . . . . . . . . . . . . . . . . . .
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Chapter 3: Proxy Vs Real Geometric

3.1 Introduction . . . . . . . . . . . .
3.2 Experiment . . . . . . . . . . . .
3.2.1 Methodology . . . . . . .
3.2.2 Single Iteration . . . . . .
3.2.3 Results . . . . . . . . . . .
3.3 Discussion . . . . . . . . . . . . .
3.4 Summary . . . . . . . . . . . . .
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4.4
4.5
4.3.2 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Chapter 5: A Back-testing
Numerical Methods . . .
5.1 Introduction . . . . . .
5.2 Experiment . . . . . .
5.2.1 Methodology .
5.2.2 Single Iteration
5.2.3 Results . . . . .
5.3 Discussion . . . . . . .
5.4 Summary . . . . . . .
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the Optimal Level of

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Chapter 6: Agent-Based Modelling of Optimal

Numerical Methods . . . . . . . . . . . . . . .
6.1 Introduction . . . . . . . . . . . . . . . . . .
6.2 Platform . . . . . . . . . . . . . . . . . . . .
6.3 Model . . . . . . . . . . . . . . . . . . . . .
6.4 Experiment . . . . . . . . . . . . . . . . . .
6.4.1 Methodology . . . . . . . . . . . . .
6.4.2 Results . . . . . . . . . . . . . . . . .
6.5 Discussion . . . . . . . . . . . . . . . . . . .
6.6 Summary . . . . . . . . . . . . . . . . . . .
Leverage using
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Leverage
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Model using
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Chapter 7: Conclusion and Future Work . . . . . . . . . . . . . . . . . . 107

7.1 Summary of the Work . . . . . . . . . . . . . . . . . . . . . . . . . . 108
7.2 Future Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
List of Figures
3.1
The flow-chart of the sampling process of the proxy and the real
geometric mean. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2 The series of prices of UNH between 17/01/2001 and 04/08/2011. .
3.3 The series of returns of UNH between 17/01/2001 and 04/08/2011.
3.4 The cumulative equity returns of leveraged and unleveraged investment in of UNH between 17/01/2001 and 04/08/2011. . . . . . . .
3.5 Plot of the series of the proxy and the real geometric mean of the
unleveraged investments. . . . . . . . . . . . . . . . . . . . . . . . .
3.6 Plot of the difference between the proxy and the real geometric mean
of the unleveraged investments. . . . . . . . . . . . . . . . . . . . .
3.7 The boxplot of the proxy of the geometric mean and the real geometric mean of the returns of unleveraged investments. . . . . . . . . .
3.8 Plot of the series of the proxy and the real geometric mean of the
leveraged investments. . . . . . . . . . . . . . . . . . . . . . . . . .
3.9 Plot of the difference of the series of the proxy and the real geometric
mean of the leveraged investments. . . . . . . . . . . . . . . . . . .
3.10 The boxplot of the proxy of the geometric mean and the real geometric mean of the returns of leveraged investments. . . . . . . . . . . .
4.1
4.3
4.2
4.4
4.5
4.6
5.1
5.2
5.3
The plot of the geometric means calculated using numerical methods

and geometric Brownian motion. . . . . . . . . . . . . . . . . . . .
The boxplot of the geometric mean using numerical methods and
based on the geometric Brownian motion. . . . . . . . . . . . . . .
The plot of the difference of the geometric means between numerical
methods and geometric Brownian motion. . . . . . . . . . . . . . .
The plot of the level of leverage calculated using numerical methods
and geometric Brownian motion. . . . . . . . . . . . . . . . . . . .
The plot of the difference of the level of leverages between numerical
methods and geometric Brownian motion. . . . . . . . . . . . . . .
The boxplot of the level of leverage using numerical methods and
based on the geometric Brownian motion. . . . . . . . . . . . . . .
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The series of prices of NDAQ between 01/11/2002 and 19/10/2007. . 77

The series of returns of NDAQ between 01/11/2002 and 19/10/2007. 77
The series of the optimal level of leverage and of the geometric Brownian motion level of leverage of an investment in NDAQ between
01/11/2002 and 19/10/2007. . . . . . . . . . . . . . . . . . . . . . . . 78
List of Figures
5.4
5.5
5.6
5.7
6.1
6.2
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6.5
6.6
The series of cumulative equity return of an investment in NDAQ

between 01/11/2002 and 19/10/2007 considering three different approaches of leverage: unleveraged, optimally leveraged, and excessive
leveraged. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plot of the dynamic of the optimal level of leverage. . . . . . . . . . .
Plot of the average value of the optimal level of leverage per iteration.
The boxplot of the log of the end of period equity return of the
optimally leveraged vs. the geometric Brownian motion leveraged
investment; the boxplot of the log of the end of period equity return
of the optimally leveraged vs. the unleveraged investment; and the
boxplot of the log of the end of period equity return of the optimally
leveraged vs. the excessively levearaged investment. . . . . . . . . . .
The plot of the log of the end of period returns of leveraged agents,
N=10 agents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
N=10 agents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
N=100 agents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The boxplot of the log of the end of period returns of leveraged agents,
N=100 agents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
N=1000 agents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
N=1000 agents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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List of Tables
3.1
Statistical analysis of the series of the proxy and the real geometric
mean of the unleveraged investments. . . . . . . . . . . . . . . . . . . 48
3.2
Statistical test of the difference between the proxy of the geometric

mean and the real geometric mean of unleveraged investments. . . . . 48
3.3
Statistical analysis of the series of the proxy and the real geometric
mean of the leveraged investments. . . . . . . . . . . . . . . . . . . . 52
3.4
Statistical Test of the difference between the proxy of the geometric

mean and the real geometric mean of leveraged investments. . . . . . 52
4.1
Statistical analysis of the geometric mean of using the geometric

Brownian motion approach and the numerical methods to calculate
the optimal level of leverage. . . . . . . . . . . . . . . . . . . . . . . . 61
4.2
Comparison between geometric Brownian motion approach and numerical methods of the geometric mean using the optimal level of
leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
4.3
Statistical analysis of the optimal level of leverage of the use of the

geometric Brownian motion approach and the numerical methods. . . 64
4.4
Comparison between geometric Brownian motion approach and numerical methods of the optimal level of leverage. . . . . . . . . . . . . 64
5.1
Statistical analysis of the log of the end of period equity return of unleveraged ln(EoP (1)), geoemtric Brownian motion leverage ln(EoP (lgbm )),
optimally leveraged ln(EoP (l )) and excessively leveraged investment
ln(EoP (10)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
5.2
T-Test of the difference between the log of the end of period equity
return of optimally leveraged investment and geotmric Brownian motion leveraged investment (GM (l ) = GM (lgbm )); the difference between the log of the end of period equity return of optimally leveraged investment and unleveraged investment (GM (l ) = GM (1));
and the difference between the log of the end of period equity return
of optimally leveraged investment and excessive leveraged investment
(GM (l ) = GM (1)). . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
6.1
Statistical analysis of the log of the ends of period returns, N = 10

agents. Opt = optimally leveraged, Unl = unleveraged and Exc =
excessively leveraged. . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
List of Tables
6.2
6.3
6.4
6.5
6.6
T-test results between the log of the end of period return of the
optimally leveraged agent (Opt) and the unleveraged agent (Unl);
and the optimally leveraged agent and the excessively leveraged agent
(Exc). N = 10 agents. . . . . . . . . . . . . . . . . . . . . . . . . . . 98
Statistical analysis of the log of the ends of period returns, N = 10o
T-test results between the log of the end of period return of optimally
leveraged agent (Opt) and unleveraged agent (Unl) and optimally
leveraged agent and excessively leveraged agent (Exc). N = 100 agents.100
Statistical analysis of the log of the ends of period returns, N = 1000
T-test results between the log of the end of period return of optimally
leveraged agent (Opt) and unleveraged agent (Unl) and optimally
leveraged agent and excessively leveraged agent (Exc). N = 1000
agents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Chapter 1
Introduction
This thesis uses numerical methods to calculate the optimal level of leverage and
tests the ability of the optimal level of leverage using numerical methods to improve
individuals investment performance. I assume that investment performance is the
end of period equity and equity is the amount of capital of the agent. For example,
if an investor with an initial equity of $1,000 opens a long position of 100 shares of
security A, which its price per share is $100, the leverage is 100 x $100 - $1,000 =
$9,000 and the level of leverage is 100 x $100 / $1,000 = 10.
This exposure expands the investors equity returns and can have a significant
impact of stock returns on equity returns. For example, suppose there is a scenario in
which two period returns of an investment in a single stock with a value of $100 and
with a stock returns of 8% and -10%. We also assume that the capital is reinvested
in the end of each period. If the level of leverage is 1, this means that the leverage is
0, and the equity increases to $108 in the first period, and, in the second period, the
equity decreases -10% to $97.20. Consequently, the cumulative equity return would
be -2.8%. However, if the level of leverage is 10, the equity increases to $180 [100*(1
+ 8%*10)] in the first period, and, in the second period, the equity decreases to $0
[180 * (1 - 10% * 10]. Consequently, the cumulative equity return would be -100%.
Hence, what dictates the equity return is the combination of stock return and the
level of leverage. Thus, in order to improve the individual investment performance,
Chapter 1. Introduction
the appropriate use of leverage is as crucial as the appropriate selection of the stock.
In this chapter, I present the introduction of this thesis. This chapter is organized
as follows. In Section 1.1, I present the motivation of this thesis. In Section 1.2,
I present the research objectives. In Section 1.3, I describe the contributions of
this thesis. In Section 1.4, I present the outlines the general structure. Finally, in
Section 1.5, I present the publications originated from this thesis.
1.1
Motivation
In this section, I present the motivation of this thesis. Nowadays, leverage plays a
very important role in the financial markets. New instruments designed to facilitate
leveraged investments such as Contract for Difference (CFD) in conjunction with
technological advances in the electronic markets make leverage accessible for every
type of investor, from small individual investors up to big pension funds. CFD
is an informal contract between a broker and his client (Norman 2009). Using
CFD, broker controls the level of exposure of the client and is more interested in
allowing clients to take leverage than using stocks. For example, in 2007, according
to UK Financial Service Authority (FSA), 30% of the volume on the London Stock
Exchange was driven by leveraged investments (FSA 2007).
However, to the best of my knowledge, there are relatively few studies relating
leverage and Computational Finance. The existing papers analyse the implication
of leverage on the financial market as a whole (Geanakoplos 2009; Thurner, Farmer,
and Geanakoplos 2011). However, no previous research has analysed the implication
of leverage to an individuals investment performance.
Computational Finance provides tools to experiment and to simulate hypotheses
regarding different aspects of finance. There is a considerable amount of research
on trading systems using Computational Finance tools (Lo and MacKinlay 1990;
LeBaron 2000; LeBaron 2002; LeBaron 2006; Martinez-Jaramillo and Tsang 2009;
Iori and Chiarella 2002), but such research has not taken into account leverage.
1.1. Motivation
Studies considering leverage and individual investment performance in Computational Finance are relevant for three reasons.
Firstly, recent studies about leverage demonstrate that an excessive level of leverage is considered irrational behaviour (Geanakoplos 2009; Thurner, Farmer, and
Geanakoplos 2011). When agents obtain positive equity returns, they can be frustrated if the level of leverage is low because such returns could be higher if the
agent was more leveraged. This belief encourages the agent to increase their level
of leverage in the next period. However, this behaviour is based on a naive belief
rather than rational reasoning because there is no model to indicate whether the
increment of the level of leverage is appropriate.
Secondly, the equity return formula has two components: the stock return and
the level of leverage. Additionally, the level of leverage is linear in the equity return
formula (Peters 2010). This means that leverage has the ability to modify the
impact of the stock return on the equity return and, consequently, on an individuals
investment performance. For example, a positive stock return can lead to negative
equity return if the level of leverage is negative.
Thirdly, leverage can lead the investor to ruin. For example, suppose that an
investor is 10 times leveraged and the stock return is -10%, the equity return is 100%. Therefore, the end of period return is -100%, and then after the -100% equity
return, the investor has no more capital to invest and, consequently, would not be
able to open any position.
Leverage has the ability to impact the investment performance. However, if used
on an excessive level, leverage can lead investor to bankruptcy. Thus, if excessive
level of leverage is bad for investments, could leverage be good on some level? Is
there an optimal level of leverage? If yes, could it be measured?
Kelly (1956) demonstrated that in binomial games with positive expectation,
there is one specific value of leverage which maximises the geometric mean or the
end of period wealth. He proposed a model to obtain this value and this model was
called the Kelly criterion. Today, one of the possible uses of the Kelly criterion is
to determine the optimal level of leverage on investments considering the possible

returns on different discrete scenarios. However, the Kelly criterion is not suitable
for determining the optimal level of leverage in continuous games when the number
of possible outcomes is unlimited, as with financial returns.
Rotando and Thorp (1992) propose the Kelly criterion version for continuous
gambling games. But the use of the Kelly criterion for continuous gambling games
is not straight forward. Continuous games can assume infinite number of outcomes
and the Kelly criterion was designed to assume a finite number of outcomes. Hence,
they assumed that the returns in the financial market are normally distributed and
such distribution should be transformed to quasi-normal distribution by cutting off
the tails in order to limit the number of outcomes and respect the Kelly criterion
original assumptions.
In order to obtain a more realistic approach, Peters (2010) introduces a new
model to obtain the optimal level of leverage using geometric Brownian motion. He
demonstrated that the optimal level of leverage is simply the estimation of log-return
divided by the variance of log-return. In this model, the objective is to estimate the
appropriate expected return and variance.
These three authors assume that the objective is to find the level of leverage
that maximises the geometric mean of the historical financial returns. Their models
yield a closed-form solution. In order to develop their models, they assume that
the historical financial returns are normally distributed, and ignore the existence of
fat-tails. However, Cont (2001) demonstrates that financial returns are not normally
distributed and exhibit fat-tails. This means that if analytical models that assume
the normal distribution are used to calculate the optimal level of leverage of a
historical financial returns, then they will underestimate the probability of extreme
returns and, consequently, underestimates the risk of default. The result is that it
could lead investors to use an excessive level of leverage which could be harmful to
the investors investment performance. For this reason, I argue that it is necessary
to develop models to optimize the level of leverage that relax the assumption of
1.2. Research Objectives
normal distribution of the series of historical financial returns.

In the next section, I present the research objectives of this thesis.
1.2
Research Objectives
The research objectives of this thesis are to introduce a numerical method to calculate the optimal level of leverage that allows the relaxation of the assumption of
normal distribution of the series of financial returns; and to test the ability of this
method to improve investment performance. Thus, the hypotheses of this research
are that using numerical methods, the geometric mean of the historical financial
returns using numerical methods is superior to the geometric mean of the historical
financial returns using analytical methods; and that the use of the optimal level of
leverage using numerical methods improves investment performance.
I use two different approaches in this thesis. In the first approach, in order to
test the hypothesis that the value of the optimal level of leverage is more appropriate
than using analytical methods, I assume that the agents objective is to maximise
the end of period return. Maximising the end of period return is the same as
maximising the geometric mean (Williams 1936, Latane 1959). Thus, similarly to
analytical models, I assume that the optimal level of leverage is the level of leverage
that maximises the geometric mean of the series of the historical financial returns.
Thus, the test is a T-test of difference between the series of the geometric mean
of the series of the leveraged historical financial returns calculated using numerical
methods and the series of the geometric mean of the series of the leveraged historical
financial returns calculated using an analytical model with a closed-form solution.
In the second approach, I compare the individual end of period equity return
under three different experimental treatments using an agent-based model of an
order-driven market. In the first treatment, the agent maintains her level of leverage
equal to 1. In the second treatment, the agent maintains her level of leverage equal
to the value calculated using numerical methods. Finally, in the third treatment,
the agent maintains her level of leverage equal to 10.

I use two statistical tests in order to analyse the outcomes under these treatments. The first test is a T-test of the difference of the series of the end of period
equity returns of optimally leveraged investment and the unleveraged investment.
The second test is a T-test of the difference of the series of the end of period equity
returns of optimally leveraged investment and the excessively leveraged investment.
In the next section, I summarise the contributions of this thesis.
1.3
Summary of Research Contributions
In this section, I describe the contributions of this thesis. The general contributions
of this thesis are the proposal of numerical methods to optimize the level of leverage
and the demonstration that the use of the optimal level of leverage using numerical
methods improves investment performance. The main advantage is that the use of
numerical methods allows the calculation of the optimal level of leverage directly
using the formula for the geometric mean. This allows me to relax the assumption
of the normal distribution of financial returns and, consequently, reduces the risk of
to underestimating extreme returns.
In order to do this, I assume that the investors objective is to maximise the end
of period equity return. Thus, this serves to measure investment performance, and
the end of period equity return can be represented by the geometric mean of the
equity returns (Williams 1936, Latane 1959).
There are three specific contributions of this research. The first contribution is
to show that a commonly-used proxy of the geometric mean, which is widely used
in the current literature, fails to accurately estimate leveraged returns. This proxy
uses the arithmetic average and the variance of the stock returns (Parramore and
Watsham 1997). However, this proxy assumes that returns can be characterised
by the first two moments and ignores the fat-tailed return distributions that are
observed in actual empirical data (Cont 2001).
1.4. Overview and Structure
The second contribution is the introduction of a novel trading strategy which

uses numerical methods in order to calculate the optimal level of leverage. Previous
studies have proposed analytical models in order to calculate the optimal level of
leverage. However, these models assume that returns are normally distributed (Kelly
1952; Rotando and Thorp 1992, and Peters 2010). By using numerical methods in
order to optimise the level of leverage, I am able to avoid this assumption and hence
avoid under-estimating extreme returns (Cont 2001). Moreover, I show that my
trading strategy exhibits superior performance to a strategy which does not use
leverage, under an analysis which uses historical data from all components of the
S&P 500 index. By performing this back-testing, I am able to avoid making any
assumptions about the distribution of returns. This is in contrast to existing studies
which simply assume that returns are normally distributed, and do not evaluate their
performance using empirical data (Kelly 1952; Rotando and Thorp 1992, and Peters
2010).
Finally, the third contribution is the introduction of a leveraged component of
agents decision making into an agent-based model of a financial market. Previous
models have used expected utility optimisation as a framework for agents trading
decisions. In contrast, my model uses the aforementioned trading strategy in order
to decide the quantity of orders by numerically-optimising the level of leverage. By
so doing, I am able to use this agent-based model to evaluate the potential effect of
market impact on the performance of my leverage-based trading strategy. To the
best of my knowledge, this is the first attempt to systematically evaluate the effect
of market-impact on the performance of leverage-based trading.
In the next section, I present the structure of the thesis.
1.4
Overview and Structure
This thesis consists in seven chapters, including the current one. In Chapter 2, I
present the literature review of this thesis.
10
In Chapter 3, I discuss the estimation of the returns on leverage. In the literature,
there is a widely used approximation of geometric mean that employs the arithmetic
average and the variance of the stock return (Parramore and Watsham 1997) but
ignores the kurtosis. I discuss the use of this formula for leveraged equity return
instead of stock return.
In Chapter 4, I propose a numerical method in order to calculate the optimal
level of leverage. The advantage of the use of numerical methods is that, differently
of the analytical models existing on the literature, the method proposed in this thesis
allows me to relax the assumption of normal distribution of the series of financial
returns and, consequently, undermine the risk of underestimation of extreme returns.
In Chapter 5, using the historical daily price of the components of the S&P 500
Index, I back-test the use of the optimal level of leverage using numerical methods. I
compare the end of period returns of the optimally leveraged investment to geometric Brownian motion leveraged, unleveraged and excessively leveraged investment,
respectively.
In Chapter 6, I employ an agent-based model in order to experiment the use of
the optimal level of leverage in a totally controlled environment. I introduce three
leveraged agents regarding their approach of leverage, the optimal level of leverage
using numerical methods, the unleveraged and the excessive level of leverage, in
an order-driven model proposed by Iori and Chiarella (2002). Then, I simulate it
regarding to three different sizes of market, 10, 100 and 1000 agents in the JASA
platform (Phelps 2007).
Finally, in Chapter 7, I summarize the main findings of this thesis and conclude.
I also discuss ideas for future research.
In the next chapter, I present the publications originated from this thesis.
1.5. Publications
1.5
11
Publications
There are two publications from this thesis. Firstly, material from Chapter 4 has
been peer-reviewed and published as:
Sbruzzi, E. and S. Phelps: 2011. Optimal Level of Leverage using Numerical
Methods. In, 7th Conference of the Portuguese Finance Network, Aveiro,
Portugal.
Secondly, material from Chapter 6 has been submitted as:
Sbruzzi, E. and S. Phelps: 2013. Testing leverage-based trading strategies
under an adaptive-expectations agent-based model. In, 12th International
Conference on Autonomous Agents and Multiagent Systems (AAMAS 2013).
In the next chapter, I review the literature of the thesis.
Chapter 2
Literature Review
In this chapter, I present the literature review of this thesis. Firstly, in Section 2.1,
I review the literature on leverage. Secondly, in Section 2.2, I review the literature
on models to estimate returns. Thirdly, in Section 2.3, I review the literature of the
investors objective function. Fourthly, in Section 2.4, I demonstrate how to relate
geometric mean, end of period return and level of leverage. Fifthly, In Section 2.5,
I present the existing models to optimize the level of leverage. Sixthly, in Section
2.6, I review the literature on the agent-based modelling. Finally, in Section 2.7, I
present the summary of the chapter.
2.1
Leverage
In this section, I present the literature review of leverage and its implication to the
individual investors performance and the financial market as a whole. Breuer (2002)
argues that leverage can be thought of as elasticity; indicating the responsiveness of
the value of equity to changes in the value of overall stocks:
kt = lt rt
(2.1)
where kt is the equity return, lt is the level of leverage and rt is the stock return. Note
that stock return, rt , is different of equity return kt . Stock return is the percentage
14
Chapter 2. Literature Review
difference of price along of two period time:
rt =
Pt
1
Pt1
where Pt is the price on the period of time t. Consequently, the impact of the stock
return on the equity return depends on the level of leverage of the position.
As changes in the value of equity are equal to changes in the stock portfolio,
leverage is conventionally defined as the ratio of assets to equity. Furthermore, by
assuming that the stock return expectation is approximately zero and that variance
is the representation of risk, Leverage increases the variance of the equity return
and, consequently, increase the risk of the equity return:
kt2 = lt2 rt2
(2.2)
where k 2 is the risk of equity return.

However, using some derivatives instruments such as futures, this incremental
risk associated to the leverage is off balance sheet and leads the regulators uninformed about to the institutions exposure to risk.
Breuer also argues that leverage can have two effects: (1) by definition it creates
and enhances the risk of default by market participants; and (2) it increases the
potential for rapid deleveraging - the unwinding of partially debt financed positions
by market participants - which can cause major disruptions in financial markets by
exaggerating market movements (Breuer 2002). The larger the leverage, the smaller
is the price change that may be needed to trigger an unwinding of the position.
While any unleveraged position would require similar actions, leveraged positions
may amplify this destabilizing mechanism and increase volatility more rapidly.
The increment of the stock volatility and its impact of the market are also
analysed by (Geanakoplos 2009; and Thurner, Farmer, and Geanakoplos 2011).
They demonstrate that leverage can become too high during boom times and too low
during bad times, i.e., leverage is cyclical. They suggest that this situation is caused
2.1. Leverage
15
by the funds competition for new investors. During boom times, higher leverage
hedge funds show superior returns and these hedge funds use such returns to attract
new investors. This competition creates a bubble in leverage and, consequently, a
bubble in the financial markets.
Khandani and Lo (2007; 2008) demonstrate that the use of leverage was quite
common among quantitative equity market-neutral strategies, where the higher
leverage ratios were used by those managers engaged in high-frequency margin overflow strategies because those strategies exhibited the lowest volatilities and highest
Sharpe ratios.
Adrian and Shin (2010) point out the relationship between leverage and liquidity; there is a positive correlation between leverage and the financial intermediaries
and commercial bank balance sheet. They demonstrate that, on one hand, the commercial banks and financial intermediaries target a fixed leverage ratio; and, on the
other hand, for households, there is a strongly positive relationship between changes
in total assets value and changes in leverage. Furthermore, they state that leverage
is pro-cyclical. The adjustments of the leverage and price reinforce each other amplifying the financial cycle and, due to the size of the financial intermediaries, this
strongly influences the liquidity, possibly leading to unwinding as observed during
the period between the crisis in July and August 2007 (Khandani and Lo 2007).
Brunnermeier and Pedersen (2005) explore the predatory characteristics of the
combination of leverage, liquidity and the overreactions of strategies. The bear
market can force traders and financial intermediaries to liquidate their position to
cover their margin calls, and provided that others players have this information, it
can lead other players to trade in the same direction, resulting in a withdraw of
liquidity from the market. This activity makes liquidation costly and leads to price
overshooting.
According to Loeys and Panigirtzoglou (2005), leverage is considered an important driver of how much the market reacts to news. Leverage increases volume
without a similar increment in the number of participants. This leads to the con-
16
centration of the risk in fewer hands. Leverage also increases the probability of
bankruptcy and can force investors to close the position in hostile conditions, which
would force the price down, exacerbating volatility. Furthermore, volatility and
leverage are positively correlated and volatility causes leverage.
The conclusion that leverage and volatility are positively correlated is consistent
with the optimal leverage model for non-ergodicity as introduced by Peters (2010).
Using geometric Brownian motion, he demonstrates that the optimal level of leverage
is simply the estimation of log-return divided by variance of log-return. Hence, the
objective is to estimate the appropriate return and variance.
Domian, Racine and Wilson (2003) use a continuous time model to derive distributions for leveraged portfolios over long periods. They demonstrate that expected
return is linear in leverage in a single-period CAPM model, but concave in the
continuous time model.
From the literature, leverage is a way to expand profitability. These characteristics create the expectation to gain huge amount of money in shorter period.
Therefore, it can affect the investors behaviours with consequences to the financial
market. The point is that, together with the expansion of the profitability, there is
a natural increase in the probability of bankruptcy.
I assume that behaviour is irrational if the investor increase the level of leverage
without any mathematical optimization of the level of leverage dictating this increment. Hence, the combination of irrational behaviour and probability of bankruptcy
can be extremely harmful for the individual investor and, consequently, to the financial market. If an individual agent is leveraged and in bankruptcy, there is a
probability that this agent does not repay its margin assumed. For this reason,
the counterpart of this position, the lender, can also have the consequences of this
situation. If the number of bankruptcy agent is low, the impact of this situation in
the financial system is low and, therefore, the chance of this to be absorbed by the
market is higher. However, if the number of bankruptcy agent high, the chance of
this to be absorbed by the market is low and, consequently, this can collapse the
2.2. Return Estimation
17
financial market.
There is a competition for new investors and, particularly during boom times,
this competition is reinforced by the increase in the level of leverage. Thus, the
number of agents will increase their exposure and the level of leverage will increase
with the duration of the boom times. Naturally, this situation creates bubbles.
However, besides creating bubbles, this competition increases the impact of the
bearing market on the financial system sustainability, due to the huge number of
agents leveraged.
Although the literature on leverage focuses on the consequences to the market, it
is important to see the consequences of leverage to the individual investor. I assume
that the financial market is a result of the interaction of different agents. Hence,
instead of the contribution with techniques to use leverage in order to improve the
financial market, this thesis aims to contribute with techniques to the individual
investor to use leverage in their investment.
In the next section, I review the literature on the estimation of the returns.
2.2
Return Estimation
In this section, I review the literature on the appropriate estimator for the returns.
The reason is that in Chapter 3, I test the ability of the proxy of the geometric
mean to be used as an estimator of the real geometric mean of leveraged returns.
The debate about the appropriate estimator for returns has its origin in Williams
(1936), who demonstrated that speculators, in a multi-period framework, should be
concerned with the geometric mean instead of the arithmetic average. The main
argument is that arithmetic average does not consider the non-linearity of returns
present on exponential compound series, like financial series, which is only captured
by geometric mean (Latane 1959).
Latane (1959) and Williams (1936) argue that, empirically, the investors objective is to maximise the end of period wealth. Thus, the estimator has to be able to
18
represent short-term returns which can be compounded to represent the long-term

returns.
However, due to its simplicity, the most widely used formula to estimate the
return is average arithmetic (AA) as described below:
n
1X
rt
n t=1
(2.3)
where AA is the arithmetic average, rt is the return obtained on time t.

However, there is an important issue that should be taken into account. This
formula does not consider the non-linearity of returns; that is, negative returns have
similar impacts to positive returns.
This is an issue because the end of period wealth is a consequence of the cumulative return which is not linear. Thus, in order to capture the non-linearity,
the alternative formula to estimate the return is the geometric mean formula as
described below:
n
Y
1
(1 + rt ) n 1
GM =
(2.4)
t=1
where GM is the geometric mean of returns.

Thus we see that the arithmetic average is biased. Jacquier et al (2003) demonstrate that, on one hand, this bias increases positively with time and it over-estimates
the end of period wealth. On the other hand, without the use of computer software,
the calculation of the geometric mean is not straight forward. In order to solve this
issue, a common approach is to relate the geometric mean to the arithmetic average
and the variance (Latane 1959). Accordingly, the proposed formula is:
GM '
2
2
(2.5)
where GM is the approximation of the geometric mean and 2 is the variance.

This approximation is widely used in the literature because it permits one to work
with the geometric mean in a closed-form solution. Consequently, it is straightfor-
2.2. Return Estimation
19
ward to differentiate and obtain a closed solution of the model.

0
I demonstrate how the proxy of the geometric mean of the return, GM , as shown
in Eq. (2.5), is obtained using Taylor approximation. Lets define x = ln(1 + GM ).
Thus from Eq. (2.4):
n
x=
1X
ln(1 + rt )
n t=1
Assuming 1 < rt 1 and using a Taylor expansion, we obtain:

n
1X
rt 2 rt 3 rt 4
x=
(rt
+
+ ...)
n t=1
2
3
4
Thus:
E(r2 ) E(r3 ) E(r4 )
x = E(r)
+
+ ...
2
3
4
where E(a) =
1
n
Pn
t=1
at . Assuming that rt is so small that if i > 2 then E(ri ) = 0:
x E(r)
E(r2 )
2
(2.6)
Note that GM = ex 1. Thus, using Taylor expansion and Eq. (2.6):
GM = x +
x2 x 3 x4
+
+
+ ...
2!
3!
4!
Assuming that if a + b > 2 then E(ra )E(rb ) = 0 and E(ra )b = 0, then the proxy
of the geometric mean is:
GM x +
x2
2!
(2.7)
Substituting Eq. (2.6) in Eq. (2.7):

2
E(r )
E(r2 ) (E(r) 2 )
GM E(r)
+
2
2
0
Simplifying Eq. (2.8):
(2.8)
20
GM E(r)
E(r2 ) E(r)2
2
(2.9)
Since the arithmetic average is = E(r), and the variance is 2 = E(r2 )E(r)2 ,
I obtain Eq.(2.5):
GM
2
2
In order to obtain the result the closed-form solution Eq. (2.5), that the proxy of
the geometric mean is the arithmetic average minus half of the variance, the model
has three assumptions. The first assumption is that the returns are always greater
than minus one and less or equal to one. This means that I assume that there is
no return less or equal to -100%, i.e., there is no probability of default. The second
assumption is that the stock returns are so small that the estimation of the return
power any value superior to two is zero. Finally, the third assumption is that if the
sum of the value of the power of the return is superior to two then the product of
the estimation of the return is also zero. The consequence of the second and the
third assumption is that the model assumes that the value of any statistical moment
superior to two is 0. Thus, the value of the skewness and the kurtosis is zero.
In the next section, I review the literature on the investors objectives.
2.3
Investors Objective Function
In this section, I review the literature on the investors objective function. The
reason is that, in Chapter 4, I assume that the investors objective is to use the
geometric mean approach in order to optimize the level of leverage.
Studies of optimal level of leverage are associated with debates of individual
investors objective function. In the literature, the investors objective function can
be divided in two different approaches: mean-variance (Markowitz 1952) and growth
optimal portfolio (Kelly 1956 and Latane 1959). Leverage is linear in the mean-
2.3. Investors Objective Function
21
variance approach, and concave in the growth optimal portfolio approach. Due to
linearity of leverage, studies of leverage are irrelevant in the mean-variance approach,
because even when leverage is introduced into the parameters of the model, it does
not alter the model itself; i.e., the model is independent of leverage. However, due to
the non-linearity of leverage in the growth optimal portfolio approach, the study of
leverage is important because the introduction of leverage on the parameters alters
the results of the model.
There is a very important debate about the objectives of individual investors.
While Markowtiz (1952) developed the mean-variance method to determine the
optimal portfolio to the next period; Kelly (1956) and Latane (1959) argued that
the main objective of the individual investor is to maximise the end of period wealth;
hence, the investor should be concerned about the capital rate of growth which could
be measured using the geometric mean.
This debate continued during the 1960s and 1970s. On one hand, Breiman (1961)
argues that on a long sequence of trials, the game objectives are to minimise the
time to reach the target level of wealth, or to maximise the value of the end of
the period wealth. Breiman (1961) and Hakansson (1971a; 1971b) show that the
optimal strategy to attain both objectives is to maximise the expected value of the
log of the terminal wealth which is the same as maximising the geometric mean of
return.
On the other hand, Samuelson (1971; 1979) argues that geometric mean maximisation was only one among many investment rules and there is no rationale to
suppose that it is the best. He shows that the geometric mean rule leads to suboptimal expected utility and, because the end of period expected is the sum of the
utility for each period, the end of period wealth under geometric mean rule will also
be sub-optimal.
The debate was theoretical with each author advocating different rules by using complex mathematical models. The reason is that during that period, the
use of numerical methods was extremely difficult because of the primitive level
22
of computer technology compared to todays technology. The lack of technology

obstructed the debate for more than 20 years. However, during the 1990s and the
2000s, new authors such as MacLean, Ziemba, and Blazenko (1992), Ross (1999),
Hunt (2002), Leippold, Trojani, and Vanini (2004), Christensen (2005) and Estrada
(2010), restarted the debate, but at this time, using numerical methods to analyse,
simulate and compare different rules similar to the theory proposed in the 1970s.
Debates about investor objectives are associated with debates about the model
to measure the investment performance, risk-return or geometric mean. The meanvariance approach is associated with the risk-return formula, and growth optimal
portfolio is associated with the geometric mean formula. The risk-return formula is:
RR =
(2.10)
where RR is the risk-return and and are the arithmetic average and the standard
deviation of the historical returns, respectively.
The alternative methodology to calculate the return is the geometric mean formula:
n
Y
1
GM =
(1 + rt ) n 1
(2.11)
t=1
A debate about the ideal methodology to measure average return has its origin in
Williams (1936), who demonstrates that speculators, in a multi-period framework,
should be concerned about the geometric mean instead of the arithmetic mean.
The main argument is that risk-return does not consider the non-linearity of returns
present on exponential compound series, like financial series, and such characteristics
are only captured by the geometric mean (Latane 1959).
In order to introduce leverage, Eq. (2.10) can be rearranged, and consequently
the leveraged risk-return formula (RRL) is:
RRL =
l
= RR
l
(2.12)
2.4. Geometric Mean, Leverage and End of Period Return
23
where l is the level of leverage. Note that leverage is monotonic and linear in the
risk-return formula. For this reason there is no level of leverage that maximizes
the Eq. (2.12). Hence this formula is not able to be used to optimizes the level of
leverage. Rearranging Eq. (2.11), the geometric mean formula (GM(l)) is:
GM (l) =
n
Y
(1 + rt l) n 1
(2.13)
t=1
From Eq. (2.13), note that leverage is neither monotonic nor linear in the geometric mean formula. For this reason, different models have been proposed to obtain
the level of leverage that optimize the geometric mean formula.
In the next section, I review the relation between geometric mean, end of period
return and level of leverage.
2.4
Geometric Mean, Leverage and End of Period

Return
In this section, I demonstrate how to relate the geometric mean, the end of period
return and the level of leverage. This section is divided in two subsections. In the
first subsection, I present the impact of the level of leverage in a single period equity
return. And, in the section subsection, I demonstrate the impact of the level of
leverage in the end of period return and on the geometric mean.
2.4.1
Single Period Equity Return
In this subsection, I demonstrate that the end of period return is dependent on

the stock return and on the level of leverage. Similar to Section 2.3, I assume that
instead of maximising stock returns, the investors objective is to maximise the end
of period equity which depends on the stock return and on the level of leverage.
The level of leverage is:
24
lt =
St
Kt
(2.14)
where lt represents the level of leverage, St represents the market value of the total
securities and Kt represents the equity value. For simplicity, no transaction costs
are considered. The leverage is:
Lt = St Kt
(2.15)
where Lt is the leverage. The value of the portfolio of stocks is:
St = Pt Qt
(2.16)
where Pt represents the price and Qt represents the quantity. I assume that the
level of leverage is represented by Eq. (2.14) and the market value of the position
is represented by Eq. (2.16). Thus, extending the model to two time periods, t and
t + 1, the stock return to the next period is represented by rt , insomuch:
Pt+1 = Pt (1 + rt+1 )
(2.17)
where Pt+1 represents the price for the next period. Assuming that Qt+1 = Qt ,
substituting Eq. (2.17) into Eq. (2.16) and rearranging:
St+1 = St (1 + rt+1 )
(2.18)
where the market value of the portfolio in the next period is St+1 . From Eq. (2.18),
the market value of the portfolio depends on the stock return. Assuming that the
leverage is fixed from time t to time t + 1, Lt+1 = Lt , substituting Eq. (2.18) into
Eq. (2.14) and rearranging :
Kt+1 = Kt (1 + rt+1 lt+1 )
(2.19)
25
where the equity for the next period is Kt+1 . From the Eq. (2.19), equity is dependent on the stock return and on the level of leverage. The equity return is:
kt+1 =
Kt+1
1
Kt
(2.20)
where kt is the equity return at time t. Thus, substituting Eq. (2.19) in Eq. (2.21),
the equity return is:
kt+1 (lt+1 ) = rt+1 lt+1
(2.21)
Note that the equity return is the product of stock return and the level of leverage. This means that the level of leverage is the impact of the stock return on
the equity return. Leverage has the ability to completely modify the impact of the
stock return because the level of leverage can assume negative values. For example, assuming that the stock return is +1%, the position is short and the level of
leverage is 3. The short position means that the level of leverage can be rewritten
as -3. Thus, the equity return is -3%, i.e., even if the stock return is positive, +1%,
the equity return is negative -3%. Therefore, if the end of period equity return is
the consequence of cumulative single period equity return and the objective is to
maximise the end of period equity return, leverage is relevant because of its direct
impact on the single equity return.
In the next subsection, I demonstrate the impact of the level of leverage in the
end of period return and on the geometric mean.
2.4.2
Geometric Mean and End of Period Return
In this subsection, I demonstrate that the end of period return can be represented by
the geometric mean of the equity return and they are functions of the stock return
dynamic process and the level of leverage dynamic process. I also demonstrate that
what maximises the end of period equity is the same that maximises the geometric
mean of the equity returns. Initially, substituting Eq. (2.21) in Eq. (2.19), the next
26
periods equity is:
Kt+1 = Kt (1 + kt+1 )
(2.22)
From Eq. (2.22), the equity on the next period is a function of the equity return.
Proceeding similar calculation, the equity on the next period, t + 2, is:
Kt+2 = Kt+1 (1 + kt+1 ) = K0 (1 + kt+1 )(1 + kt+2 )
(2.23)
From Eq. (2.23), after two periods of time the equity is a function of the cumulative equity returns over the time t and t + 1. Thus, applying similar calculations
until the end of period, t = T , and considering the initial time equal to 0, the end
of period equity is:
T
1
Y
KT = K0
(1 + kt+1 )
(2.24)
t=1
From Eq. (2.24), the end of period equity is a function of the cumulative equity
returns. the geometric mean of is:
T
1
Y
(1 + kt+1 )] T 1
GM = [
(2.25)
t=1
Substituting Eq. (2.25) in Eq. (2.24):
KT (GM ) = K0 (1 + GM )T
(2.26)
Eq. (2.26) shows that the end of period equity is a function of the geometric
mean of the equity returns.
In order to verify if the maximisation of geometric mean of equity returns leads
the maximisation of end of period equity, I differentiate Eq. (2.26):
dKT
= T K0 (1 + GM )T 1 > 0
dGM
(2.27)
27
According to Eq. (2.27), the impact of the geometric mean on the end of period
equity is positive. Thus, the maximisation of the geometric mean of the returns
leads to the maximisation of the end of period equity.
According to Eq. (2.21), equity return is a function of the stock return and the
level of leverage. Thus, Substituting Eq. (2.21) in Eq. (2.26) and considering the
initial t 1 = 0:
KT (GM (r, l)) = K0 (1 + GM (r, l))T
(2.28)
From Eq. (2.28), the end of period equity is a function of the stock return
dynamic process and level of leverage dynamic process. The end of period return is:
KT (GM (r, l)) = (1 + GM (r, l))T 1
(2.29)
Thus, from Eq. (2.29), the end of period return also depends on the series of
stock return r and level of leverage l.
Assuming that the stock returns dynamic process is exogenous, i.e., out of the
investors control; the variable of control is the level of leverage. For this reason, in
order to maximise the geometric mean of the equity return, investors should to be
concerned on the level of leverage that maximises the geometric mean of the equity
return. Hence, the appropriate estimator of the geometric mean of leveraged returns
is relevant.
In Section 2.2, I stated that the proxy of geometric mean as Eq. (2.5) has three
assumptions. Firstly, the returns is greater than minus one and less or equal to one.
Secondly, the stock returns is so small that the estimation of the return power any
value superior to two is zero. Finally, the sum of the value of the power of the return
is superior to two then the product of the estimation of the return is also zero.
However, this proxy assumes that the returns are normally distributed and this
implicates that the value of the skewness and kurtosis is 0, i.e., extremes are barely
on the distribution. The key point is that leverage expands the impact of the stock
28
return (Breuer 2002) and, naturally, increases the kurtosis. Thus, it contradicts
the assumptions of the advocators of the approximation for the geometric mean.
Therefore, the leverage characteristics could indicate that the approximation is not
appropriate for the equity return.
For example, if we expand our original example of two periods stock returns to
four periods stock return, the stock returns are +8%, -10%, +10% and +5%. Then,
if we assume that the level of leverage is 1, the arithmetic average, the proxy of
geometric mean and the real geometric mean of the equity returns are 3.25%, 2.84%
and 2.93%, respectively. Note that the value of the estimators are considerable
near to one another. Furthermore, this result suggests that the arithmetic average
overvalues the rate of return and the proxy of the geometeric mean undervalues the
rate of return, which agrees with the findings in Jacquer et al. (2003).
However, if we assume that the level of leverage is 10, the stock return remains
unchanged, but, the equity return are +80%, -100%, +100% and +50%. Consequently, the arithmetic average, the proxy of geometric mean and the real geometric
mean of the equity returns are 32.50%, -8.63% and -100%, respectively. Note that
in this case, there is a considerable distance between the estimators. Furthermore,
this result demonstrates that the arithmetic average and the proxy of geometric
mean are not able to capture the real rate of return, which is -100%. The reason
for this failure is that both estimators do not capture the risk of default which is
increasing in leverage; i.e., the higher the level of leverage, the higher the risk of
default (Breuer 2002).
In the next section, I review the literature on optimal leverage models.
2.5
Optimal Leverage Models
In this section, I present the three existing models to optimize the level of leverage.
The first model is the Kelly criterion which assumes normal distribution of the
returns and discrete number of possible outcomes (Kelly 1956). The second model
2.5. Optimal Leverage Models
29
is the Rotando and Thorp model which assumes normal distribution of the returns
and continuous number of possible outcomes (Rotando and Thorp 1992). Finally,
the third model is the Peters model which assumes normal distribution of the returns
and that price follows a geometric Brownian motion (Peters 2010).
This section is divided in three subsections. In the first subsection, I describe
the Kelly criterion. In the second subsection, I describe the Rotando and Thorp
model. Finally, in the third subsection, I describe the Peters model.
2.5.1
The Kelly Criterion
In this subsection, I describe the Kelly criterion. The importance of studies on

leverage is not recent. Kelly (1956) demonstrates that there is an optimal level of
leverage for binomial games such as coin tossing games. He assumes that the main
objective of the player is to maximise the trials expected value and, consequently,
the end of period cumulative return. He also demonstrates that if you have a positive
trials expected value, the size of your leverage depends upon two factors: the value
of your expected value and the probability of ruin. This model is called the Kelly
criterion. Originally, the Kelly criterion consists of a model to maximise returns on
a binomial game similar to coin tossing. The model is described below.
Suppose that on each trial the win probability is p > 1/2 and, consequently, the
probability of loss is q = 1 p < 1/2. Once the outcome probability is defined, the
question is to decide the amount of capital Bi to bet on each trial with the objective
to maximise the expected value of the end of trials wealth, E(Xn ). Let Ti = 1 if
the ith trial is a win and Ti = 1, if the ith trial is a loss. Furthermore, letting
X0 be the initial capital, then Xi = Xi1 + Ti Bi , for i = 1, ..., n and, consequently
P
Xn = X0 + ni=1 Ti Bi , then
n
X
E(Xn ) = X0 +
(p q)E(Bi ) > 0
(2.30)
i=1
Assuming p > 1/2 > q and, consequently the expected value of the end of
30
trials wealth E(Xn ) is positive, the objective is to find the amount of the available
capital which should be bet, Bi , and the amount of capital that should be saved
for later trials, Xi1 . On one hand, if the player decides to bet all the capital, this
increases the probability of ruin. On the other hand, if he decides to bet the minimal
capital, the player reduces the probability to maximise the value of the end of trials
wealth. Therefore, there is some optimal level of leverage or optimal fraction, l,
which balances the objective to maximise the expected value with the restriction to
minimise the probability of ruin.
In the coin-tossing game, since the gambling probability and the payoff at each
trial are the same, it is clear that the optimal level of leverage is the same for all
trials. This assumption of fixed leverage helps us to comprehend the purpose of the
Kelly criterion. Maximising the expected end of trial wealth is similar to maximising
the expected value of the growth rate coefficient or the geometric mean, GMk (l):
GMk (l) = E[log
Xn 1
] n = p log(1 + l) + q log(1 l)
X0
q
p
1+l 1l
(2.32)
l2 + 2l(p q) 1
(1 l2 )2
(2.33)
GMk0 (l) =
GMk00 (l) =
(2.31)
where GMk (l) is the geometric mean approximation on the Kelly criterion and
0 l < 1. From Eq. (2.33), the function GMk (l) is concave in l, hence it can be
maximised. Furthermore, solving Eq. (2.32), the result is that the optimal level of
leverage is l = p q.
In the next subsection, I describe the Rotando and Thorp model.
2.5.2
The Rotando and Thorp Model
In this subsection, I describe the Rotando and Thorp model. The Kelly criterion
cannot be directly used on investments. The main reason is that with games like coin
2.5. Optimal Leverage Models
31
tossing there are a discrete number of possible outcomes, whereas with investments,
the number of possible outcomes is continuous. In order to use the Kelly criterion
in financial markets, the original model proposed in Eq. (2.31) should be modified
and adapted to represent continuous outcomes. This modification is proposed by
Rotando and Thorp (1992). They propose a new model incorporating continuous
outcomes, but respecting the Kellys original insight: the definition of the optimal
level of leverage in order to maximise the end of period wealth or the end of period
return, E[log(Xn/X0)].
According to Rotando and Thorp (1992), trading financial securities can be
considered a continuous game. Thus, in order to model the possible outcomes, they
assume that financial returns are Normally distributed. However, the simple use of
the unaltered Normal probability distribution is inadequate because this distribution
allows an infinite range of possible returns. Therefore, they modify the standard
normal curve using a correction term for chopping off the tails (Rotando and
Thorp 1992). This results in new parameters, h and , which serves to maintain the
mean and the standard deviation at values similar to those of the standard Normal
distribution..
Similar to binomial games, the objective in this model is to find out the level of
leverage that maximises function GMrt (l), which in this case is:
Z
log(1 + rl)dN (r)
GMrt (l) =
(2.34)
where GMrt is the geometric mean approximation if the Rotando and Thorp model.
Z
GMrt (l) =
log(1 + rl)[h +
1
22
2 /22
e(r)
(2.35)
where A = 3 and B = + 3.
The demonstration of first-order and the second order conditions of Eq. (2.35)
is complicated. However, numerical methods can be used to obtain the value of l
that maximises the function GMr t(l). For example, simulating the model proposed
32
for the 59 year period from 1926 to 1984, with the = 0.058 and = 0.216 by
using numerical methods, Rotando and Thorp (1992) found that the optimal level
of leverage is l = 1.17.
In the next subsection, I describe the Peters model that uses the geometric
Brownian motion.
2.5.3
Geometric Brownian Motion
In this subsection, I describe the Peters model that uses the geometric Brownian
motion. Assuming that the price follows a geometric Brownian motion, and consequently, that returns are log-normally distributed (Hull 2009), Peters proposes a
different model to optimize the level of leverage (Peters 2010). Suppose that the
price process is:
p(t) = p0 [exp (
2
)t + W (t)]
2
(2.36)
where the Wiener process W(t) is normally distributed.

Introducing the leverage, the estimated leveraged log-return and its variance are
respectively:
l = l
(2.37)
l2 = l2 2
(2.38)
where l is the level of leverage.

The estimated log-return of the leveraged investment to the next period is:
GMp (l) = E[log(pt+1 )] log(pt ) = (l
2
)
2
Substituting Eq. (2.37) and Eq. (2.38) into Eq. (2.39) gives:
(2.39)
2.6. Agent-Based Modelling
33
GMp (l) = (l
l2 2
)
2
(2.40)
In order to obtain the optimal level of leverage, Eq. (2.40) is differentiated with
respect to l and the result is set to zero. Then, the optimal level of leverage is:
l =
(2.41)
where l is the optimal level of leverage.

According to the Peters model, the optimal level of leverage is the estimated
log-return divided by its variance.
One of the drawbacks of these models is that they assumes that the financial
returns is normally distributed and, consequently, ignores the presence of fat-tails
(Cont 2001). With the objective of relax this assumption, in Chapter 4, I propose
a numerical method in order to optimize the level of leverage. In the next section,
I review the literature on agent-based modelling.
2.6
Agent-Based Modelling
In this section I review the literature on agent-based modelling. The reason is that
in Chapter 6, I test the ability of the optimal level of leverage to improve investment
performance in an agent-based modelling experiment.
Agent-based modelling has the ability to go beyond the traditional economics
because it considers the market as a multi-agent system wherein each agent has
particular characteristics that differs from other agents, while the traditional economics assume that every agent is similar and rational (Chakraborti et al. 2011).
The traditional economic approach with closed solutions was crucial to allow the
proposition of analytical models which would be unfeasible without the assumption
of similarity and rationality among the agents. However, advances in the technology and in the computer platforms such as StarLogo (Resnick 1996), NetLogo (Sklar
34
2007), Repast (Collier 2003), JABM (Java Agent-Based Modelling) (Phelps 2012)
and JASA (Java Auction Simulation API) (Phelps 2007) have enabled the progress
in numerical approaches and simulation instead of analytical approach in order to
model any aspects of different areas of research, for example, in the Biology and in
the Sociology (Chakraborti et al. 2011).
Naturally, agent-based modelling research has been proposed for Economics and
Finance. According to LeBaron (2000; 2006), the combination of agent-based models
and computational methods in finance creates a new sub-area called agent-based
computational finance. One use of agent-based computational finance is artificial
stock market which consists on a set of tools that intends to replicate artificially
the stock market (LeBaron 2002). This is a controlled environment which allows
one to run experiments using artificial agents in order to analyse a wide variety of
hypotheses from the literature of finance.
Different agent-based models have been proposed with the objective of investigating how different trading strategies may affect the dynamics of price, bid-ask
spreads, trading volume and volatility. The literature of agent-based modelling for
finance used in the thesis evolves along of the time as follows: Firstly, The proposal
of agent-based modelling for finance is not recent in the literature, its origins are
contained in Grossman (1976) who proposed a model with heterogeneous agents
that interact with each other. One of the most important debates in agent-based
modelling area is how to model the artificial agent, with its individual characteristics, heterogeneity and behaviour (LeBaron 2000). Lettau (1997) proposes a very
simple model where agents should decide between a risk and risk free asset according
to personal utility function.
Secondly, Bak, Paczuski and Shubik (1996) propose a model which assumes that
orders are input according to a price line. They assume that there are N agents and
N/2 stocks. The agent is a buyer if he does not hold the stock, and a seller if he
holds a stock. Agents can only sell stock if they hold one, and they can only buy
stock if they dont hold one. This means that there is no leverage in this model.
35
Agents advertise the value that they intend to buy (sell) the stock and the trade
occurs when the prices cross, i.e., the offer to buy is superior to the price to sell. At
this moment, the seller trades with the buyer that offers the highest price. In the
case of no trade, the prices are updated to the next round.
Thirdly, Maslov (2000) introduces a model with limit and market orders. This
is an important step towards the replication of the real financial market. In their
model there is no strategy pre-defined. Traders simply collect the last transaction
price, p(t) and aggregate a small variation on this price . Thus, the order to sell
is above the current price, p(t) + , and the order to buy is below the current price
p(t) . In the first moment, there is no trade, because the highest order to buy is
inferior to the lowest order to sell. However, in this model, agents are not allowed to
update or cancel their orders along of the rounds. Consequently, after some rounds,
the probability of having the order matched increases because the new current price
p(t + n) indicates one new order to sell p(t + n) + that could be inferior to the
original price to buy p(t) .
Fourthly, Lux and Marchesi (2001) propose that agents decide according to the
combination of three components. The first component is the fundamentalist. The
fundamentalist component uses the fundamental value of the security, For example,
in the case of stocks, the intrinsic value of the company is calculated using the
information in its balance sheet. The fundamentalist component indicates to sell
(buy) when the price is bigger (smaller) than the stock intrinsic value or fundamental
price.
The second component is the chartist. The chartist component uses the historical data instead of the balance sheet. The chartist component can be divided into
contrarians and trend followers. Contrarians are based on the existence of overreaction on the stock returns (Lo and MacKinlay 1990). This indicates to buy (sell)
past losers (winners). Unlike the contrarians, trend-followers are based on the existence of trends on the financial series (Brock, Lakonishok and LeBaron 1992). This
indicates to buy (sell) past winners (losers).
36

The thrid component is the noise. The noise trader is not possible to be char-
acterized. The noise trader does not follow any standard or pre-defined behaviour.
This indicates decisions using no strategy and zero-intelligence.
Finally, Iori and Chiarella (2002) introduce an order-driven market model with
heterogeneous agents trading via a central order matching mechanism in a double
auction, dispensing with the need for a market maker. At the moment of ordering,
agents face three different parameters in their decision: the price (limited at some
value or marketed), the direction (long or short) and the volume or the level of
leverage. Iori and Chiarella (2002) propose model in which agents, in combination
with three different components (the fundamentalist, the chartist, and the noise,
mentioned above) have intelligence in order to decide the price and the direction.
However, there is no intelligence in order to decide the level of leverage, rather we
simply assume that each agent can only trade one stock at a time:
i
Ert,t+n
= g1i
p f pt
+ g2i rLi + ni et
pt
where g1i is the weight of fundamentalist component which is positive, and g2i is the
weight of the chartist component which is positive in the case of trend followers,
and negative in the case of contrarians.
Each agent has different values for g1i and g2i which is normally distributed.
The parameter rLi is the moving average value of the return over Li period and is
uniformly and independently distributed. The position is opened according to the
i
i
value of the expectation of return Ert,t+n
. Positive (negative) Ert,t+n
indicates long
(short) position.
Iori and Chiarella (2009) extend the model proposed by Iori and Chiarella (2002)
introducing intelligence in the volume, proposing that agents should invest according
to their individual exponential utility of wealth function U (w) = eW . Consequently, the optimal quantity agent i is:
i (p) =
log(Epi(t+n) ) log(p)
i t p
37
where t is the standard deviation of the historical return and i is the risk-profile
value.
The risk-profile value is a parameter which measures how adverse to risk is the
agent; i.e., the higher the risk-profile value, the more risk-adverse is the agent. Note
that the optimal volume is negative correlated to the risk-profile value; the more
risk-adverse is the agent, the smaller is the volume.
For the purpose of this thesis, I use the order-driven model as proposed by Iori
and Chiarella (2002) and Lux and Marchesi (2001). I assume that this model is
the best representation of trade price expectation scheme because the order-driven
model assumes that the individual agent decision has the three components, the
fundamental component, the technical component and the noise component. The
only difference is the weight of each particular component to the agents. There are
two advantages of the model. Firstly, the components weight are randomly among
the artificial agents and all of the three component are taken into account. This
is natural that the real agents use a mix of signal during their decision process.
Intuitively, It is difficult to conceptualize that some agent is 100% technical and 0%
fundamentalist and vice-versa. The most natural assumption is that each agent is
unique and gives different weights to each component, and this situation is captured
by the model.
Secondly, agents are assumed to be boundedly rational, thus their behaviour
has simple characteristics, that can be described by the components. The model
is in line with the agents behaviour characteristics because his price expectation is
simply the combination of the three components and the historical prices.
In terms of the quantity specified in orders, Iori and Chiarella (2009) propose
an extension based on the utility function. In Section 2.2, I discussed the difference
between the approach of the investors objective and the reasons to use the geometric
mean with the leverage in this thesis. For this reason, in Chapter 6, I assume that
instead of maximising their utility function, the agents objective is to maximise the
geometric mean of the equity returns.
38

In the next section, I present the summary of this chapter.
2.7
Summary
In this chapter, I reviewed the literature of this thesis. This chapter is divided in
six sections, including the current one. In the first section, I reviewed the literature
on leverage and its implication to the individual investment performance. Leverage
allows to enhancing the equity return. This characteristic encourages excessively
level of leverage which can lead the investor to default with consequences to the
financial market as a whole. Even though the investors behaviour impacts the
financial market, the literature is concentrated in the impacts of leverage on the
financial market as a whole instead of the individual investors behaviour. For this
reason. this thesis aims to contribute with techniques to the individual investor to
use leverage in their individual investment.
In the second section, I reviewed the literature on the return estimation because
in Chapter 3, I discuss the ability of that models to be employed to estimate the
leveraged returns. The proxy of geometric mean as Eq. (2.3) has two assumptions.
Firstly, all returns are greater than minus one and less or equal to one. Secondly,
the stock returns are so small that the estimation of the return power any value
superior to two is zero. Due to its assumptions, the proxy of geometric mean ignores
the presence of kurtosis. The kurtosis increases in leverage (Thurner, Farmer and
Geanakoplos 2011), and is one of the characteristics of the series of financial returns
(Cont 2001).
In the third section, I reviewed the literature on the investors objective function
because in Chapter 4, I assume that the investors objective is to use the geometric
mean approach in order to optimize the level of leverage. There are two different
approaches of the investors objective function: The mean-variance approach and
the geometric mean approach. Furthermore, leverage is monotonic and linear in the
risk-return formula, but is neither monotonic nor linear in the geometric mean. For
2.7. Summary
39
this reason, different models have been proposed to obtain the level of leverage that
optimize the geometric mean formula.
In the fourth section, I demonstrated how to relate the geometric mean, the end
of period return and the level of leverage. This section is divided in two subsections.
In the first subsection, I demonstrate that the end of period return is dependent
on the stock return and on the level of leverage. And, in the section subsection, I
demonstrate that the end of period return can be represented by the geometric mean
of the equity return and they are functions of the stock return dynamic process and
the level of leverage dynamic process.
In the fifth section, I reviewed the literature on the existing optimal leverage
models on the literature. There are three different models. The first model is the
Kelly Criterion that serves to determine the optimal level of leverage on investments
considering the possible returns on different discrete scenarios (Kelly 1956). The
second model is the Rotando and Thorp model that is an adaptation of the Kelly
criterion for continuous gambling games, such as financial returns (Rotando and
Thorp 1992). Finally, the third model is the Peters model, which assumes that
prices follow a geometric Brownian motion and, consequently, the optimal level of
leverage is a function of the arithmetic average and the variance of the stock return
(Peters 2010). One of the drawbacks of these models is that they assumes that the
financial returns is normally distributed and, consequently, ignores the presence of
kurtosis (Cont 2001). With the objective of relax this assumption, in Chapter 4, I
propose a numerical method in order to optimize the level of leverage.
Finally, In the sixth section, I reviewed the literature of agent-based modelling
because in Chapter 6, I employ this environment to test the ability of optimal level
of leverage to improve the investment performance. Agent-based modelling allows
me to replicate the stock market artificially in order to make controlled experiments
and simulations. There are no studies in the literature that employ an agent-based
model to test the optimal leveraged models, and its consequence to the individual
investors performance.
40

In the next chapter, I show that a commonly-used proxy of the geometric mean,
which is widely used in the current literature, fails to accurately estimate leveraged
returns.
Chapter 3
Proxy Vs Real Geometric Mean
on Leverage
In this chapter, I demonstrate that the proxy of geometric mean existing in the literature fail in order to estimate leveraged returns. I analyse the use of the geometric
mean approximation widely used in the literature, in leveraged equity return. The
formula of the proxy is a function of the mean and the variance, and does not take
into account the probability of default(see Section 2.2); it assumes that the value of
the kurtosis of the equity equity returns, which increases with the level of leverage,
is zero. For this reason, I test the ability of the geometric mean approximation to
estimate the real rate of return of leveraged investments. I find that the proxy is
accepted as an estimator of the geometric mean of the unleveraged returns but is
not accepted as an estimator of the geometric mean of the leveraged returns.
The chapter is structured as follows: In Section 3.1, I present the introduction
of this chapter. In Section 3.2, I present the experiment of the proxy and the real
geometric mean of the returns of unleveraged and leveraged investments. In Section
3.3, I discuss the results of the experiment. Finally, in Section 3.4, I present the
summary and the contribution of this chapter.
42
Chapter 3. Proxy Vs Real Geometric Mean on Leverage
3.1
Introduction
In this thesis, I assume that the investors objective is to maximise the end of period
return; and, in the existing literature, the formula proposed to represent the end of
period equity returns is the geometric mean (Williams 1936 and Latane 1959). There
is an approximation of this model that is widely used in the literature of finance
which uses arithmetic average and variance (Parramore and Watsham 1997). This
proxy exists in order to make the calculation of the geometric mean more friendly
with a closed-form solution.
In this chapter, I analyse the reliability of this proxy for leveraged investments.
Similar to the example above, the intuitively perception is that, even this approximation could be used on stock returns or unleveraged investments, it is not possible
to be used on leveraged investments because it does not take into account the risk
of default and the value of the kurtosis of the equity returns which increases in the
level of leverage.
Therefore, I perform two simulation experiments. In the first experiment, I
test the hypothesis that the proxy can be used as a real geometric mean of the
unleveraged returns. In the second experiment, I test the hypothesis that the proxy
can be used as a real geometric mean of the leveraged returns. The results are that
the proxy can be used as a real geometric mean of the unleveraged returns, and the
proxy should not be used as a real geometric mean of the leveraged returns.
In the next section, I present the results of the experiment that consists in the
test of the ability of the proxy of geometric mean to replicate the real geometric
mean of leveraged investments.
3.2
Experiment
In this section, I present the results of the experiment that consists in the test of
the ability of the proxy of geometric mean to replicate the real geometric mean of
leveraged investments. This section is divided in three subsections. In the first sub-
3.2. Experiment
43
section, I describe the methodology of the experiment. In the second subsection, I

present an example of iteration in order to show how the data point in the generated series is obtained. Finally in the third subsection, I present the results of the
experiment.
3.2.1
Methodology
In this subsection, I describe the methodology of the experiment. In order to run

the experiment, I split the experiment in two different treatments. In the first
treatment, I test the hypothesis that the proxy of geometric mean is able to replicate
the geometric mean of the unleveraged investments. In the second treatment, I test
the hypothesis that the proxy of geometric mean is able to replicate the geometric
mean of the leveraged investments.
These hypotheses are tested through the T-test of the difference of the proxy and
Collect daily data of every component of S&P 500 Index between 2000 and 2010.
Randomly select one component of the S&P 500 Index, one window period with 1000
days or more and one value for the level of leverage between 1 and 10.
Calculate and record the proxy of

the geometric mean of unleveraged
and leveraged returns
Calculate and record the real

geometric mean of unleveraged
and leveraged returns
Figure 3.1: The flow-chart of the sampling process of the proxy and the real geometric mean.
44
the real geometric mean. As shown in Figure 3.1, in order to test the hypotheses,
the sampling process consists in three steps. Firstly, I collect daily data of every
component of the S&P 500 index between January of 2000 and December 2010, 2766
trading days. This provides a dataset with 1.383 x 106 items of data. Secondly, From
the dataset, I randomly select one component of the S&P 500 index, one window
period with 1000 days or more and one value for the level of leverage between 1 and
10. Thirdly, I calculate and record the proxy and the real geometric mean of the
unleveraged and leveraged investments. I repeat this sampling process a total of
1000 times. The number of possible selected series is 758 x 103 . Thus, our sample
represents approximately 0.13% of the total (1/758).
The sampling process produces four different sets of data each consisting of 1000
data point: the series of the proxy of the geometric means and the series of geometric
means of equity returns for unleveraged and leveraged investments using Eq. 2.4
and Eq. 2.5, respectively.
In the next subsection, I present an example of iteration in order to show how
the data point in the generated series is obtained.
3.2.2
Single Iteration
In this subsection, I describe in detail a single iteration in order to demonstrate

how the proxy and the real geometric means of the equity return are calculated and
collected over the iterations. Firstly, I randomly select one stock component of S&P
500 Index and the window period. For this example, I randomly select the stock of
United Health Group Inc (ticker:UNH) and the window period of 2652 days between
17/01/2001 and 04/08/2011 as showed in Figure 3.1.
Secondly, I generate the series of return according to the following formula:
rt =
Pt
1
Pt1
(3.1)
where rt is the return, Pt is the current price and Pt1 is the previous price as showed
3.2. Experiment
45
70
60
Price
50
40
30
20
10
0
500
1000
1500
2000
2500
Figure 3.2: The series of prices of UNH between 17/01/2001 and 04/08/2011.
in Figure 3.2. As the level of leverage of unleveraged investment is 1, I use the series
of stock return as the series of equity return of the unleveraged investment.
Thirdly, I randomly select the value of the level of leverage which is uniformly
distributed between 1 and 10. In this iteration the random level of leverage is 2.42.
Combining the series of the return and the random level of leverage, and using Eq.
3.1, I generate the series of the equity return of leveraged investment as showed in
Figure 3.3.
Fourthly, using the series of return, Eq. 2.4 and Eq. 2.5, I calculate the proxy of
the geometric mean and the real of the geometric mean of the unleveraged investment
and of the leveraged investment, respectively. The proxy of the geometric mean is
0.0470% and the real geometric mean is 0.0473% for the unleveraged investment;
and the proxy of the geometric mean is 0.0273% and the real geometric mean is
0.0287% for the leveraged investment.
Finally, these results are stored in four different series of data: a) the series of the
46
0.5
0.4
Stock Return
0.3
0.2
0.1
0
0.1
0.2
0
500
1000
1500
2000
2500
Figure 3.3: The series of returns of UNH between 17/01/2001 and 04/08/2011.
proxy values of the geometric mean of unleveraged investment, b) the series of the
real geometric mean of the unleveraged investment, c) the series of the proxy of the
geometric mean of the leveraged investment and d) the series of the real geometric
mean of the leveraged investment.
In the next subsection, I present the results of the experiment.
3.2.3
Results
In this subsection, I present the results of the experiment. A single iteration only
produces four series consisting of one data point: a) proxy values of the geometric
mean of unleveraged investment, b) the real geometric mean of the unleveraged
investment, c) the proxy of the geometric mean of the leveraged investment and d)
the series of the real geometric mean of the leveraged investment.
This single iteration is obviously not sufficient to test the hypothesis that the
difference of the proxy of the geometric mean and the real geometric mean of the
3.2. Experiment
47
25
Level of Leverage = 2.42
Cumulative Equity Returns
20
15
10
5
0
Unleveraged
500
1000
1500
2000
2500
Figure 3.4: The cumulative equity returns of leveraged and unleveraged investment
in of UNH between 17/01/2001 and 04/08/2011.
unleveraged and leveraged investment are zero because of the lack of data per series. Therefore, this iteration is replicated 1000 times in order to generate 1000
data points per series. Thus, after the replication, there are four different series of
data with 1000 data points: a) the series of the proxy values of the geometric mean
of unleveraged investment, b) the series of the real geometric mean of the unleveraged investment, c) the series of the proxy of the geometric mean of the leveraged
investment and d) the series of the real geometric mean of the leveraged investment.
These series are used in the two different tests. In the first test, I attempt to
reject the null hypothesis that the average value of the difference between the series
of proxy and real geometric mean of the unleveraged investment has average value
of zero. In the second test, I attempt to reject the null hypothesis that the average
value of the difference between the series of proxy and real geometric mean of the
leveraged investment has average value of zero.
48

Item
Mean
Median
Minimum
Maximum
Standard Deviation
Skewness
Kurtosis
Size
Real
Proxy
0.2102e 003 0.2089e 003

0.2396e 003 0.2393e 003
-0.0024
-0.0024
0.0020
0.0020
0.4956e 003 0.4952e 003

-0.5736
-0.5581
5.5337
5.4403
3
10
103
Table 3.1: Statistical analysis of the series of the proxy and the real geometric mean
of the unleveraged investments.
Item
P-value
Confidence Interval (Prob95%)
Null Hypothesis
GM GM = 0
0.0553
[-2.90e-08; 2.58e-06]
Accepted
Table 3.2: Statistical test of the difference between the proxy of the geometric mean
and the real geometric mean of unleveraged investments.
Test for Unleveraged Investments
From Table 3.1, the difference of the mean and the median of the proxy and the
real geometric mean of the unleveraged investments are not significant at the first
glance, which could indicate that there is no difference between the series. From
Table 3.2, the hypothesis that the difference between proxy if the geometric means
and the real geometric mean is zero is accepted with a probability of 95%. From
Figure 3.4 and Figure 3.5, it is possible to see that the values of the proxy and
the real geometric mean do not differ substantially. Finally, from Figure 3.6, it is
possible to notice that the average value of both series are very similar.
Test for Leveraged Investments

From Table 3.3, the difference of the mean and the median of the proxy, and the
real geometric mean of the leveraged investments are significant at the first glance,
which could indicate that there is difference between the series. From Table 3.4,
the hypothesis that the difference between the proxy of the geometric mean and the
real geometric mean is rejected with a probability of 95%. From Figure 3.7 and
3.2. Experiment
49
Real
Geometric Mean
x 10
0
2
4
0
200
400
Geometric Mean
800
1000
600
800
1000
Proxy
600
x 10
0
2
4
0
200
400
Iterations
Figure 3.5: Plot of the series of the proxy and the real geometric mean of the
unleveraged investments.
x 10
Difference of Geometric Mean
3
2
1
0
1
2
3
4
0
200
400
600
800
1000
Iterations
Figure 3.6: Plot of the difference between the proxy and the real geometric mean of
the unleveraged investments.
50
x 10
Geometric Mean
1.5
0.5
0.5
Real
Proxy
Figure 3.7: The boxplot of the proxy of the geometric mean and the real geometric
mean of the returns of unleveraged investments.
Real
Geometric Mean
0.5
0
0.5
1
0
200
400
600
800
1000
600
800
1000
Geometric Mean
Proxy
0
0.05
0.1
0.15
0.2
0
200
400
Iterations
Figure 3.8: Plot of the series of the proxy and the real geometric mean of the
leveraged investments.
3.2. Experiment
51
0.4
0.2
0
0.2
0.4
0.6
0.8
1
0
200
400
600
800
1000
Iterations
Figure 3.9: Plot of the difference of the series of the proxy and the real geometric
mean of the leveraged investments.
0
0.1
Geometric Mean
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Real
Proxy
Figure 3.10: The boxplot of the proxy of the geometric mean and the real geometric
mean of the returns of leveraged investments.
52

Item
Mean
Median
Minimum
Maximum
Standard Deviation
Skewness
Kurtosis
Size
Real
-0.3603
-0.0063
-1.0000
0.0041 0.0043
0.4780
-0.5921
1.3510
103
Proxy
-0.0104
-0.0048
-0.1811
0.0176
-4.5300
33.4113
103
Table 3.3: Statistical analysis of the series of the proxy and the real geometric mean
of the leveraged investments.
Item
P-value
Confidence Interval (Prob95%)
Null Hypothesis
GM (l) GM (l) = 0
0
[-0.3802; -0.3221]
Rejected
Table 3.4: Statistical Test of the difference between the proxy of the geometric mean
and the real geometric mean of leveraged investments.
Figure 3.8, it is possible to see that the values of the proxy and the real geometric
mean differ substantially from each other. Furthermore, is it possible to see the
considerable amount of cases that the geometric mean of the equity return is equal
to -100%. Finally, from Figure 3.9, it is observed that the boxplot of the real
geometric mean presents values of -1. This occurs because of a number of series
generated present a geometric mean of the equity return equal to -100%.
In the next section, I discuss the results of this experiment.
3.3
Discussion
In this section, I discuss the results of the experiment in Section 3.3. The proxy
of geometric mean is a straightforward method to relate the geometric mean to the
moments of the returns because it uses the arithmetic average and the variance. It
has been widely used in the literature in order to obtain a proxy of the stock rate
of growth. In this chapter, I demonstrate that the proxy is accepted to estimate
for this purpose. One of the advantages of the use of the proxy is that this allows
the calculation of the rate of the rate of growth of the stock using a closed-form
3.4. Summary
53
solution.
However, the stock return is only one of the parameters of the equity return.
The other parameter is the level of leverage. In this experiment, I also tested the
hypothesis that proxy can also be used to estimate the rate of growth of the equity
return. The result shows that the proxy should not be used to estimate the leveraged
equity return.
In Figure 3.7, we observe that there is a considerable number of leveraged investments that result in a geometric mean value of -100% and this fact is not captured
by equation 2.5. This means that even though the investor is ruined, the proxy of
the geometric mean shows that this investor is active.
In the next section, I present the summary and the contribution of this chapter.
3.4
Summary
In this chapter, I reviewed the use of the formula proposed as a proxy of the geometric mean of the historical financial returns in light of the leveraged investment.
The formula contains the value of the arithmetic average and the variance of the
series of the equity returns. This formula is widely used in the literature because it
facilitates a closed-form solution of the analytical model.
However, leverage has the ability to expand the equity return and, consequently,
increase extreme returns. Since the formula assumes normal distribution of the
series of financial returns, this underestimates extreme returns and, consequently,
underestimates the risk of default.
The contribution of this chapter is to show that a commonly-used proxy of the
geometric mean, which is widely used in the current literature, fails to accurately
estimate leveraged returns. This proxy uses the arithmetic average and the variance
of the stock returns (Parramore and Watsham 1997). However, this proxy assumes
that returns can be characterised by the first two moments and ignores the fat-tailed
return distributions that are observed in actual empirical data (Cont 2001).
54

I tested the ability of the proxy to calculate the geometric mean of leveraged
equity returns in a similar way to that used to calculate the geometric mean of
unleveraged equity returns. The result is that, even though the proxy serves to
calculate the geometric mean of unleveraged equity returns, it does not serves to
calculate the geometric mean of leveraged equity returns because the proxy does
not consider the risk of default. For this reason, the proxy should not be used to
calculate the geometric mean of the series of leveraged returns.
The proxy of the geometric mean was an important approximation because before
the use of computer software, it was very difficult to work with numerical methods.
Thus, the closed-form solution was the best form to present and defend a theory in
the quantitative finance area. However, with the advance of computer software, the
use of numerical methods increased. Thus, numerical methods could also be used
to estimate the geometric mean which minimises the issues from the assumption of
normal distribution of the financial returns, necessary to use the proxy.
In the next chapter, I introduce a novel trading strategy which uses numerical
methods in order to calculate the optimal level of leverage.
Chapter 4
Optimal Level of Leverage using
Numerical Methods
In this chapter, I introduce a new model that uses numerical methods in order to
find the level of leverage that maximises the geometric mean of a historical equity
returns. The reason for this proposition is that the existing analytical models to
optimize the level of leverage in the literature assume the returns are normally
distributed. My insight is that, by assuming normal distribution of the returns,
these models are not able to capture the presence of the fat tails on the return
distribution (Cont 2001) and, consequently, their results could not represent the
real optimal level of leverage. However, by using numerical methods, I can relax
the assumption of normal distribution of the returns. Thus, when calculating the
optimal level of leverage, I can take into account the presence of the fat tails in
the return distribution. To the best of my knowledge this is the first algorithm for
optimising the level of leverage using the geometric mean which does not assume
that returns are normally distributed.
In order to test the ability of numerical methods to yield superior geometric
mean to analytical models, I run an experiment using numerical methods and the
most recent analytical models in the literature in the literature: the model of Peters
(2010) which assumes that the price follows a geometric Brownian motion. I find
56
Chapter 4. Optimal Level of Leverage using Numerical Methods
that the use of numerical methods results in superior estimation of the geometric
mean compared with geometric Brownian motion, even though, it results in a inferior
optimal level of leverage.
of the chapter. In Section 4.2, I describe the model in which the optimal level of
leverage is calculated using numerical methods. In Section 4.3, I present the results
of the experiment that compares two different methods to calculate the optimal level
of leverage, geometric Brownian motion and numerical methods. In Section 4.4, I
discuss the results of the experiment. Finally, in Section 4.5, I present the summary
and the contribution of the chapter.
4.1
Introduction
In Section 2.3, I demonstrated that there are two different approaches of the investors objective: the mean-variance approach and the geometric mean approach.
I also demonstrated that leverage is monotonic and linear in the risk-return formula,
but is neither monotonic nor linear in the geometric mean. For this reason, I argue
that the geometric mean formula is the appropriate model to measure the investment performance whether the investor uses leverage. Thus, the geometric mean
formula should be used to calculate the optimal level of leverage.
In Section 2.5, I described the three different models to optimize the level of
leverage in the literature. These models propose to find the level of leverage that
maximises the geometric mean of the historical leveraged returns. The first model is
the Kelly Criterion. Assuming that the investors objective is to maximise the end
of period wealth, Kelly (1956) demonstrates that for binomial games with positive
expectation, there is one specific value of leverage that maximises the geometric
mean of the returns or the end of period wealth. He introduced a model to obtain
this value called the Kelly criterion. Today, one of the possible uses of the Kelly
criterion is to determine the optimal level of leverage on investments considering
4.1. Introduction
57
the possible returns in different discrete scenarios. However, the Kelly criterion
cannot be properly used to determine the optimal level of leverage in continuous
games where the number of possible outcomes is unlimited, as with investments in
financial markets.
The second model is the Rotando and Thorp model. In order to relax the restriction of discrete scenarios with limited number of possible outcomes, Rotando and
Thorp (1992) revise the Kelly criterion for continuous gambling games. However,
the use of Kelly criterion for continuous gambling games is complicated. Continuous
games assume an infinite number of outcomes and the Kelly criterion was originally
designed to assume a limited number of outcomes. Hence, in order to limit the number of outcomes and respect the Kelly criterion assumptions, Rotando and Thorp
assumed that the returns in the financial market follow a normal distribution and
such distribution should be transformed to quasi-normal distribution by cutting off
the tails. This allows the use of the Kelly criterion in continuous games. However,
an important issue remains, namely the assumptions that the returns are normally
distributed.
Finally, the third model is the Peters model. In order to establish a more realistic approach, Peters (2010) introduces a new model to obtain the optimal level
of leverage. He assumes that asset prices follow a geometric Brownian motion and
demonstrates that the optimal level of leverage is simply the estimation of return divided by its variance. However, by assuming that prices follow a geometric Brownian
motion, Peters also assumes that returns are normally distributed.
The key point is that all three models assume that returns are normally distributed. Cont (2001) demonstrates that there is a presence of fat-tails on daily
returns, i.e, value of kurtosis superior to three. Hence, we see from empirical data
that actual returns in the real market are not normally distributed. Therefore, models that assume the normality of the returns distributions, underestimate extreme
returns and, consequently, underestimate the risk of default.
In this chapter, in order to avoid any discussion about the return distribution and
58
relax the assumption of normal distribution of the returns, I propose to estimate the
optimal level of leverage using a numerical non-parametric method. In this case, I
use a line-search method to obtain the level of leverage that maximises the geometric
mean of a series of historical returns.
In order to test the hypothesis that numerical methods yield superior geometric
mean to the Peters model, I calculate the optimal level of leverage using geometric
Brownian motion and compare this with the optimal level of leverage obtained using
numerical methods of 104 series of daily returns of the components of the S&P 500
index. In the experiment, the stock, the length of the series and the period are
randomly selected. I find that the numerical method shows superior geometric
mean to the Peters model based on the geometric Brownian motion.
In the next section, I describe the model optimal level of leverage using numerical
methods.
4.2
Numerical Methods
In this section, I describe the model in which the optimal level of leverage is calculated using numerical methods. In general, the models reviewed in Section 2.5
present the following three characteristics of leverage. Firstly, the geometric mean is
concave in leverage, and consequently, there is an optimal level of leverage. Secondly,
the optimal level of leverage is achieved analytically using those models. Finally,
the models assume the normal distributions of the returns and ignores the presence
of fat tails (Cont 2001).
The proposal of this section is that, instead of using proxies and analytical models
to obtain the optimal level of leverage, we should return to the original model of
geometric mean as described in Eq. (2.13) and use a numerical method, in this case
line-search, in order to obtain the optimal level of leverage. By so doing I am able
to relax the assumption of normal distribution of the returns.
In the line-search method (Kelley 1999), I randomly select two levels of leverage,
4.3. Experiment
59
l1 and l2 , in which each point is on a different side of the maximum value. Next, I
select two new levels of leverage, l3 and l4 . This will increase the geometric mean
value. This procedure is performed iteratively to obtain the specific level of leverage
that no other level of leverage results in a superior value of geometric mean. The
resulting level of leverage is considered the optimal.
In order to use the numerical method, I transform Eq. (2.13) and introduce the
term leverage in the geometric mean formula:
n
Y
1
GMnm (l) = [ (1 + rt l)] n 1
(4.1)
t=1
where rt l is the leveraged return at the time t. Iteratively, I use the line-search
method, in order to obtain the value of l that maximises Eq. (4.1):
n
Y
1
Max GMnm (l) = Max[ (1 + rt l)] n 1
l
(4.2)
t=1
Numerical methods have three advantages. Firstly, it is not necessary to make

any assumptions about the statistical characteristics of the data which helps us
to avoid any further discussion about the realism of the distribution selected to
represent the data. Secondly, the method is free of approximations or simplifications,
which also helps to make the methods the more realistic as possible. Finally, it is
easy to test using real data.
In the next section, I present the results of the experiment with the optimal level
of leverage using numerical methods.
4.3
Experiment
In this section, I present the results of the experiment that compares two different
methods to calculate the optimal level of leverage, geometric Brownian motion and
numerical methods. This section is divided in two subsections. In the first subsection, I describe the methodology of the experiment. And, in the second subsection,
60
I present the results of the experiment.
4.3.1
Methodology
In this subsection, I describe the methodology an experiment in which I test the

ability of numerical methods to achieve the level of leverage that optimizes the
geometric mean of the series of returns superior to the Peters model based on the
geometric Brownian motion (see chapter 2). As empirical evidence, I use the series
of daily returns of the components of the S&P 500 index between 2003 and 2010.
The data series contains 1024 days of 30 different stocks. I assume that the empirical
data is sufficient to represent financial returns.
The experiment consists of a random selection of a window of a series of prices
over 104 iterations. In order to obtain the most representative data series during
different periods of time, I randomly select three parameters on each iteration: the
stock, the length of the series, and the window period. For example, I randomly
select the series of returns of the stock of General Electric Company (ticker: GE)
between 01/02/2005 and 19/04/2007, as well as the series of returns of of the stock
of Pfizer Inc. (ticker: PFE) between 23/08/2008 and 30/11/2010.
In each iteration, I calculate two different parameters: the optimal level of leverage and the optimal leveraged geometric mean. I use two different methods: the
optimal level of leverage formula, as described by Eq. (2.41), and the numerical
methods as described by Eq. (4.2). This generates four different data series each
containing 104 data points: 1) the series of optimal level of leverage based on the
geometric Brownian motion, 2) the series of optimal level of leverage using numerical
method, 3) the series of optimal the geometric mean of the historical returns using
numerical method, and 4) the series of optimal the geometric mean of the historical
returns based on the geometric Brownian motion.
4.3. Experiment
4.3.2
61
Results
In this subsection, I present the results of the experiment. In order to compare the
methods and their results, I test two different null hypotheses. Firstly, I test the
null hypothesis that the optimal level of leverage using numerical method is similar
to the optimal level of leverage using on geometric Brownian motion. Secondly, I
test the null hypothesis that the leveraged geometric mean using numerical methods
is similar to the leveraged geometric mean using on geometric Brownian motion.
Geometric Mean
Item
GMN M
GMGBM
Mean
3.9004x104
3.8932x104
Median
2.0925x104
2.0922x104
Minimum
-3.9415x104
Maximum
0.0073
0.0073
5.6597x104
5.6463x104
Skewness
3.8271
3.8207
Kurtosis
25.5245
25.4607
104
104
Standard Deviation
Size
Table 4.1: Statistical analysis of the geometric mean of using the geometric Brownian motion approach and the numerical methods to calculate the optimal level of
leverage.
From Table 4.1, the mean and the median of the series of geometric means calculated
using the numerical methods are superior to the series of geometric means using the
geometric Brownian motion. It indicates that the numerical methods could yield to
a higher value of geometric mean than the geometric Brownian motion.
62
GMN M GMGBM
Item
Confidence Interval (P95%)
[1.66x104 ;2.16x104 ]
Null Hypothesis
Rejected
Table 4.2: Comparison between geometric Brownian motion approach and numerical
methods of the geometric mean using the optimal level of leverage .
From Table 4.2, the confidence interval of the difference between the series of
geometric means calculated using the numerical methods and the series of geometric
means using the geometric Brownian motion is positive. This demonstrates that
numerical methods yield to a higher value of geometric mean than the geometric
Brownian motion with a probability superior to 97.5%.
Numerical Methods
Geometric Mean
x 10
6
4
2
0
0
2000
Geometric Mean
6000
8000
10000
8000
10000
4000
x 10
6
4
2
0
2
0
2000
4000
6000
Iterations
Figure 4.1: The plot of the geometric means calculated using numerical methods
and geometric Brownian motion.
From Figure 4.1, there is no negative value of the geometric mean of the historical
returns of the use of numerical methods. However, there is one negative value for
the geometric mean of the use of the geometric Brownian motion.
4.3. Experiment
63
4
Geometric Mean
15
x 10
10
5
0
Numerical Methods
Figure 4.3: The boxplot of the geometric mean using numerical methods and based
on the geometric Brownian motion.
10
x 10
2
0
2000
4000
6000
Iterations
8000
10000
Figure 4.2: The plot of the difference of the geometric means between numerical
methods and geometric Brownian motion.
From Figure 4.2, there is no negative difference between the series of geometric
means calculated using the numerical methods and the series of geometric means
using the geometric Brownian motion. This demonstrates that numerical methods
yield a value of geometric mean superior to geometric Brownian motion.
From Figure 4.3, we see that the difference between the series of geometric means
64
calculated using the numerical methods and the series of geometric means using the
geometric Brownian motion is not clear. However the bottom value of the numerical
methods is superior to the minimum value of the geometric Brownian motion.
Level of Leverage
Item
LN M
LGBM
Mean
0.9621
0.9639
Median
0.7903
0.7924
Minimum
-4.7141 -4.7611
Maximum
8.0387
9.0770
Standard Deviation
1.0202
1.0292
Skewness
1.6113
1.6790
Kurtosis
8.7796
9.2992
104
104
Size
Table 4.3: Statistical analysis of the optimal level of leverage of the use of the
geometric Brownian motion approach and the numerical methods.
From Table 4.3, the mean and the median of the series of the optimal level of leverage calculated using the numerical methods are inferior to the series of the optimal
level of leverage using the geometric Brownian motion. This indicates that numerical methods could yield a lower value of optimal level of leverage than geometric
Brownian motion.
Item
Confidence Interval (P95%)
Null Hypothesis
LN M LGBM
[0.1934; 0.2428]
Rejected
Table 4.4: Comparison between geometric Brownian motion approach and numerical
methods of the optimal level of leverage.
From Table 4.4, the confidence interval of the difference between the series of op-
4.3. Experiment
65
timal level of leverage calculated using numerical methods and the series of optimal
levels of leverage using geometric Brownian motion is positive. This demonstrates
that numerical methods yield to a lower value of the optimal level of leverage than
geometric Brownian motion with a probability superior to 97.5%.
Numerical Methods
Geometric Mean
10
5
0
5
0
2000
4000
6000
8000
10000
8000
10000

Geometric Mean
10
5
0
5
0
2000
4000
6000
Iterations
Figure 4.4: The plot of the level of leverage calculated using numerical methods and
geometric Brownian motion.
From Figure 4.4, the range of the possible values of the optimal level of leverage varies between -5 and 10 in both approaches, numerical methods and geometric
Brownian motion. This demonstrates that the excessive levels of leverage, e.g. tenfold, are not rational because it has not been between the range of the level of
leverage that maximises the historical equity returns.
66
Difference of Level of Leverage
0.5
0.5
1.5
2
0
2000
4000
6000
Iterations
8000
10000
Figure 4.5: The plot of the difference of the level of leverages between numerical
methods and geometric Brownian motion.
From Figure 4.5, the difference between the series of the optimal level of leverage
calculated using numerical methods and the series of geometric means using geometric Brownian motion is distributed among positive and negative values. Hence,
visually, it is not possible to distinguish the optimal level of leverage using numerical
methods to the optimal level of leverage using geometric Brownian motion.
4.4. Discussion
67
3.5
3
Level of Leverage
2.5
2
1.5
1
0.5
0
0.5
1
1.5
Numerical Methods
Figure 4.6: The boxplot of the level of leverage using numerical methods and based
on the geometric Brownian motion.
From Figure 4.6, the difference between the series of geometric means calculated
using the numerical methods and the series of geometric means using the geometric
Brownian motion is not clear.
4.4
Discussion
The results of the experiment show that the use of numerical methods allows us
to calculate the optimal level of leverage that results in superior estimation of the
geometric mean of the historical returns compared with the use of geometric Brownian motion. The confidence interval of the difference of geometric mean of the
daily historical returns is between 1.66x104 and 2.16x104 . By using the formula
(1 + dgm )252 1, where the parameter dgm can be replaced by the value of the limits
of the confidence interval, this values represent a difference in the annual historical
returns of 4.27% and 5.59%.
68

Analytical models such as geometric Brownian motion assume that the returns
are normally distributed and ignores the presence of fat-tails. Consequently, this
underestimates extreme returns. However, numerical methods relax the assumption
of normal distribution of the returns, and do not require a closed-form solution.
This makes the calculation of the optimal level of leverage more reliable, and allows
me to obtain the correct level of leverage that maximises the geometric mean of the
historical return.
4.5
Summary
In this chapter, I introduced a new model that uses numerical method in order
to find the level of leverage that maximises the geometric mean of the series of
historical equity returns. My method uses line-search to numerically search for the
optimal level of leverage. To the best of my knowledge this is the first algorithm for
calculating the optimal level of leverage using the geometric mean approach which
does not assume that returns are normally distributed or that the price process
follows geometric Brownian motion.
Furthermore, I tested the ability of numerical methods to yield superior geometric mean to geometric Brownian motion. In order to do that, I calculated the
optimal level of leverage using numerical methods and using geometric Brownian
motion of 104 series of daily returns of the components of the S&P 500 Index. In
the experiment, the stock, the length of the series and the window period are randomly selected. I found that the numerical methods yield superior geometric mean
of the series of historical equity returns to geometric Brownian motion, even though,
when it shows inferior level of leverage.
The results of the experiments in Chapter 3 and in this chapter show the advances
caused by the use of numerical methods in the leverage models. For this reason, I
argue that the proxy and the analytical models used to calculate the unleveraged
4.5. Summary
69
equity returns cannot be directly used to calculate the leveraged equity returns
because the proxy and the models assume that the returns are normally distributed,
and ignore the presence of fat-tails and, consequently, underestimate extreme returns
present on the leveraged investments.
The contribution of this chapter is the introduction of a novel trading strategy
which uses numerical methods in order to calculate the optimal level of leverage.
Previous studies have proposed analytical models in order to calculate the optimal level of leverage. However, these models assume that returns are normally
distributed (Kelly 1952; Rotando and Thorp 1992, and Peters 2010). By using numerical methods in order to optimise the level of leverage, I am able to avoid this
assumption and hence avoid under-estimating extreme returns (Cont 2001).
In the next chapter, I show that my trading strategy exhibits superior performance to a strategy which does not use leverage, under an analysis which uses
historical data from all components of the S&P 500 index.
Chapter 5
A Back-testing of the Optimal
Level of Leverage using Numerical
Methods
In this chapter, I back-test the optimal level of leverage using numerical methods. Using empirical historical data from the components of the S&P 500 index, I
compare the investment performance of an optimally leveraged investment to the
geometric Brownian motion (Peters 2010), the unleveraged investment and the excessively leveraged investment. I find that the optimally leveraged investment outperforms the other three leveraged investment approaches. This is interesting to
back-test the effect of leverage using empirical data because it reinforce the ability of the optimal level of leverage using numerical methods to improve investment
performance.
of the chapter. In Section 5.2, the experiment is presented. In Section 5.3, I discuss
the results of the experiment. Finally, in Section 5.4, I present the summary and
the contribution of the chapter.
Chapter 5. A Back-testing of the Optimal Level of Leverage using Numerical

Methods
72
5.1
Introduction
In this section I present the introduction of this chapter. The first question that
emerges from every financial theory or financial model is: Does it work?. One
possible way to answer this question is through a back-testing of the model using the
historical data. In this chapter, in order to answer the question Does the optimal
level of leverage using numerical methods work?, I back-test the ability of this
model to improve the investment performance using the historical data.
According to Williams (1936) and Latane (1959), in a multi-period framework,
the investors objective is to maximise the end of period equity return, or the geometric mean. In Chapter 3, I demonstrated that the equity return formula has
two components: the stock return and the level of leverage. Furthermore, I demonstrated that the level of leverage is the impact of the stock return in the equity
return. Assuming that the stock return is out of the agents control (being determined by the market), in Chapter 4, I proposed a numerical method in order to find
the level of leverage that maximises the geometric mean of the equity returns of an
investment in a single stock.
In this chapter, I back-test the numerical method proposed in Chapter 4. In
order to do that, I test the ability of the use of optimally leveraged investment
to yield superior end of period return to geometric Brownian motion, unleveraged
investments and excessively leveraged investments. In the test, I use daily data of
every component of the S&P 500 index between January 2000 and December 2010
and compare four series of 1000 data points: The series contain the geometric means
of the unleveraged investments, the optimally leveraged investments, the geometric
Brownian motion leveraged investments and the excessively leveraged investment.
There are three results from the experiment. The first result is that the optimally leveraged investments results in a superior end of period equity return to
the geometric Bronian motion. The end of period equity return of the optimally
leveraged investments is approximately between 3.9 and 6.4 times the end of period
equity return of the unleveraged investments with a statistical probability of 95%.
5.2. Experiment
73
The second result is that the optimally leveraged investments results in a superior
end of period equity return to the unleveraged investments. The end of period
equity return of the optimally leveraged investments is approximately between 3.9
and 6.4 times the end of period equity return of the unleveraged investments with
a statistical probability of 95%.
The third result is that the optimally leveraged investments results in a superior
end of period equity return to the excessively leveraged investments. Considering
that the average value of the end of period equity return of the excessively leveraged
investments is -100%, i.e., default, it is not possible to calculate the improvement
caused by the use of optimal level of leverage using numerical methods. Even though,
the improvement exists because any result is better than default.
In the next section, I present the results of the experiment in which I run a
back-test of the optimal level of leverage using numerical methods.
5.2
Experiment
In this section, I back-test the ability of this model to improve the investment performance compared to the geomoetric Brownian motion, the unleveraged investment
and the excessively leveraged investment. This section is divided in three subsection. In the first subsection, I describe the methodology of the experiment. In the
second subsection, I present the example of a single iteration. Finally, in the third
section, I present the results of the experiment.
5.2.1
Methodology
In this subsection, I present the methodology of the experiment. In Chapter 4, I

proposed the use of numerical method in order to find the level of leverage that
maximises the geometric mean of the historical returns:
n
Y
1
Max GM = [ (1 + rt l)] n 1
l
t=1
74

Methods
In order to test the ability of the use of the optimal level of leverage using
numerical methods to improve the investment performance, I collect daily data of

every component of the S&P 500 index between January of 2000 and December
2010, a total of 2766 trading days. This provides a dataset of 1.383 x 106 data
points.
From the dataset, I randomly select 1000 times, one component of the S&P 500
index and one window period of 1250 daily prices. The range of possible selected
series is 758 x 103 . Thus, the sample represents approximately 0.13% of the total
(1/758). The experiment produces four different series of 1000 data: the series of
the optimally leveraged equity returns, the series of the geometric Brownian motion
leveraged equity returns, the series of the unleveraged equity returns, and the series
of the excessively leveraged equity returns.
I split the series into two portions. The first portion contains 1000 data points
which is the first 1000 days of the series, and the second portion contains the 250
data which is the last 250 days of the series. There are two different reasons for
this division. Firstly, the first portion serves to calculate the initial optimal level
of leverage using numerical methods (see Chapter 4) and the geometric Brownian
motion level of leverage (Peters 2010). The optimal level of leverage using numerical
methods is as follows:
GM (kt )
n
Y
1
= [ (1 + kt )] n 1
(5.1)
t=1
where k is the equity return. Substituting Eq. (2.21) in Eq. (5.1), the geometric
mean of the historical equity return can be expressed in terms of leverage:
n
Y
1
GM (l ) = [ (1 + rt l )] n 1
(5.2)
t=1
where l is the level of leverage that maximises the historical geometric mean and
rt is the stock return on the period t. Thus, from Eq. (5.2) the formula to calculate
the initial optimal level of leverage at time 1000 is:
5.2. Experiment
75
GM (l1 )
1000
Y
(1 + (rt l1 )] 1000 1
=[
(5.3)
t=1
Secondly, the second portion serves to obtain the back-tested investment performance, i.e., the end of period equity return. The optimal level of leverage is
calculated using the previous 1000 days stock returns at each period of the backtesting. Iteratively, this calculation is made over 250 periods. The result is the end
of period equity return:
250
Y
EQ (li , ri ) = [ (1 + li ri+1000 )] 1
(5.4)
i=1
where EQ is the end of period return of the optimally leveraged investment.

According to Eq. (2.41), the ideal level of leverage using geometric Brownian
motion on each period is:
ligbm =
i
i2
(5.5)
where lip is the ideal level of leverage using geometric Brownian motion, i and i2
are the average value and the variance of the series of the previous 1000 returns,
respectively. Thus, from Eq. (5.5) the formula to calculate the initial ideal level of
leverage using geometric Brownian motion at time 1000 is:
l1gbm =
1
12
(5.6)
Consequently, the model for the geometric Brownian motion leveraged investment is:
250
Y
EQgbm (li , ri ) = [ (1 + ligbm ri+1000 )] 1
(5.7)
i=1
where EQgbm is the end of period return of the geometric Brownian motion leveraged
investment.
Furthermore, I assume that the level of leverage of unleveraged investments is
76

Methods
one, li = 1:
250
Y
EQ1 (1, ri ) = [ (1 + ri+1000 )] 1
(5.8)
i=1
where EQ1 is the end of period return of the unleveraged investment; and I also
assume that the level of leverage of unleveraged investments is ten, li = 10:
250
Y
EQ10 (10, ri ) = [ (1 + 10ri+1000 )] 1
(5.9)
i=1
where EQ10 is the end of period return of the excessively leveraged investments.
In the next subsection, I describe the example of a single iteration.
5.2.2
Single Iteration
In this subsection, I describe in detail a single iteration in order to demonstrate

how the end of period equity return is calculated and collected over the iterations.
Firstly, I randomly select the stock and the window period. For this example, I
randomly selected the stock of NASDAQ OMX Group Inc. (ticker: NDAQ) and
the window period of price of 1250 days between 01/11/2002 and 19/10/2007 as
showed in Figure 5.1. Then, I calculate the return using the Eq. (2.17). The series
is showed in Figure 5.2.
Secondly, I split the series of return into two different portions. The first portion
contains 1000 data, between 01/11/2002 and 20/10/2006, that serves to calculate
the initial optimal level of leverage. The second portion contains 250 data points,
between 21/10/2006 and 19/10/2007, that serves to back-test and to move the first
portion window in order to calculate the optimal level of leverage over each period.
Figure 5.3 shows the optimal level of leverage dynamic process along the 250 days
of the back-testing.
Finally, I run the back-testing. The first period of the back-testing starts at the
time 1001 of the example, date 21/10/2006. The price on 20/10/2006 and on the
next day, 23/10/2006, are $36.25 and $36.92, respectively. If the formula of the
5.2. Experiment
77
50
45
40
Price
35
30
25
20
15
10
5
0
200
400
600
t
800
1000
1200
Figure 5.1: The series of prices of NDAQ between 01/11/2002 and 19/10/2007.
0.3
0.25
0.2
Stock Return
0.15
0.1
0.05
0
0.05
0.1
0.15
0.2
0
200
400
600
t
800
1000
1200
Figure 5.2: The series of returns of NDAQ between 01/11/2002 and 19/10/2007.
78

Methods
3
Geometric Brownian motion
Optimal level of leverage
2.8
Level of Leverage
2.6
2.4
2.2
2
1.8
1.6
0
50
100
150
200
250
Figure 5.3: The series of the optimal level of leverage and of the geometric Brownian motion level of leverage of an investment in NDAQ between 01/11/2002 and
19/10/2007.
stock return is Pt /Pt1 1, consequently, we have four different results. Firstly,

the equity return of the unleveraged investment is +1.85%. Secondly, the equity
return of excessively leveraged investment is +18.5%. Thirdly, from Eq. (5.4), the
optimal level of leverage is 2.2655 and, as a result, from the Eq. (2.21), the equity
return of the optimally leveraged investment is +4.19%. Finally, from Eq. (5.7), the
geometrix Brownian motion level of leverage is 2.1681 and, as a result, from the Eq.
(2.21), the equity return of the geometric Brownian motion leveraged investment is
+4.01%.
On the next day of transactions, 24/10/2006, the price is $37.40. Similarly,
the stock return or the equity return of the unleveraged and excessively leveraged
investment are +1.52% +15.2%, respectively. The optimal level of leverage and
the geometric Bronian motion leverage are 2.2817 and 2.1839, respectively. Consequently, the equity return of the optimally leveraged investment the geometric
Bronian motion leveraged investment are +3.46% +3.32%, respectively. Thus, the
cumulative equity return of the optimally leveraged investment, geometric Bronian
5.2. Experiment
79
Optimal Level of Leverage

1
0
1
0
50
100
150
200
250
50
100
150
Excessive Level of Leverage
200
250
50
100
150
Unleverage
200
250
50
100
200
250
1
0
1
0
1
0
1
0
0.5
0
0.5
0
150
Figure 5.4: The series of cumulative equity return of an investment in NDAQ between 01/11/2002 and 19/10/2007 considering three different approaches of leverage:
unleveraged, optimally leveraged, and excessive leveraged.
motion leveraged investment, unleveraged investment and excessively leveraged investment are +8.17%, +7.46%, +3.38% + 36.5%, respectively.
Applying similar calculations until the end of the period, day 1250, which is,
in fact, day 250 of the back-testing (the first 1000 days is used to calculate the
optimal level of leverage), on 19/10/2007, this generates four different series of
the end of period equity returns shown in Figure 5.4, the series of the end of period equity return of the optimally leveraged, geometric Bronian motion leveraged,
unleveraged and excessively leveraged investment, respectively. As a result, it is
possible to collect four different metrics: the end of period equity return of the optimally leveraged, the geometric Bronian motion leveraged, the unleveraged and the
excessively leveraged investment that are +28.7%, +25.9%, +10.3% and -100%, respectively. In this example, there is three differenct results. Firstly, the investment
performance of optimally leveraged investments is superior to the investment performance of unleveraged investment and the improvement is approximately 1.10 times
(+0.287/ + 0.259). Secondly, the investment performance of optimally leveraged
80

Methods
10
Optimal Level of Leverage
8
6
4
2
0
2
4
6
0
50
100
150
200
250
Figure 5.5: Plot of the dynamic of the optimal level of leverage.

investments is superior to the investment performance of unleveraged investment
and the improvement is approximately 2.78 times (+0.287/ + 0.103). Finally, the
excessively leveraged investment results in default, consequently, it is not possible
to calculate the improvement.
In the next subsection, I present the results of the experiment
5.2.3
Results
In this subsection, I present the results of the experiment. A single iteration only
provides three metrics of interest, the end of period equity returns of the optimally
leveraged, the geometric Brownian motion leveraged, the unleveraged, and the excessively leveraged investment. This single iteration is obviously not sufficient to
test the ability of the optimal level of leverage using numerical methods to improve
the investment performance because it generates four different series of end of period
equity returns with only one single data point. Therefore, in this experiment, this
single iteration is replicated 1000 times with random stocks and window periods.
Figure 5.5 shows the leverage dynamic after 1000 iterations. Note that there is
5.2. Experiment
81
10
8
Average Value
6
4
2
0
2
4
0
200
400
600
800
1000
Iterations
Figure 5.6: Plot of the average value of the optimal level of leverage per iteration.
a dynamic process of the optimal level of leverage.

Figure 5.6 shows the series of the average level of leverage per iteration. This
value varies between the minimum of -3.19 and the maximum of 9.08. The mean
value is 1.86, the median value is 1.46, and the standard deviation is 1.83. I assume
that the level of leverage of the excessively leveraged investment is ten. There is
two reasons for this assumption. The first reason is that from Figure 5.6, the range
of the mean of the optimal level of leverage is between -3.19 and 9.08. The second
reason is that in the experiment in Section 4.3, optimal level of leverage was between
-4.7 and 8.0. In both cases the optimal level of leverage is inferior to ten.
As a result of the experiment, four different series of 1000 end of period equity
returns are collected. The series of end of period return of optimally leveraged,
geometric Brownian motion, unleveraged and excessively leveraged investments. In
order to make the statistical test, this four series are transformed using natural
logarithm. The reason for transform the series is to make the range of the possible
results from [1 : ) to ( : ).
The statistical test is the t-test of the difference between three series; that is,
82

Methods
Item
ln(EoP (1)) ln(EoP (lgbm )) ln(EoP (l )) ln(EoP (10))
Mean
0.0311
0.1426
0.1543
-16.9495
Median
0.0732
0.1523
0.1662
-4.1145
Minimum
-2.5423
-3.6100
-3.1413
-280.8514
Maximum
1.4321
4.0991
4.4542
4.8017
Standard Devia0.3882
0.6516
0.6494
36.2492
tion
Skewness
-0.9115
-0.3265
-0.2609
-3.8453
Kurtosis
6.8225
8.5471
8.6500
20.2021
3
3
3
Size
10
10
10
103
Table 5.1: Statistical analysis of the log of the end of period equity return of unleveraged ln(EoP (1)), geoemtric Brownian motion leverage ln(EoP (lgbm )), optimally
leveraged ln(EoP (l )) and excessively leveraged investment ln(EoP (10)).
the difference between the series of the end of period equity returns of the optimally
leveraged and the geometric Brownian motion leverage investment, the difference
between the series of the end of period equity returns of the optimally leveraged and
the excessively leveraged investment, and the difference between the series of the end
of period equity returns of the optimally leveraged and the unleveraged investment.
These tests are in order to test the null hypothesis that the optimally leveraged
investment shows end of period equity returns equal to geometric Brownian motion
leverage investment, the optimally leveraged investment shows end of period equity
returns equal to excessively leveraged investment, and to test the null hypothesis
that the optimally leveraged investment shows end of period equity returns equal
to unleveraged investment.
From Table 5.1, the mean of the log of the end of period equity return of the
unleveraged, the geoemtric Brownian motion leveraged, the optimally leveraged and
the excessively leveraged investment are +0.0311, +0.1426, +0.1543 and -16.94, respectively. Furthermore, the median of the geometric mean of the equity return
of the unleveraged, the geoemtric Brownian motion leveraged, the optimally leveraged and the excessively leveraged investment are +0.0732, +0.1523, +0.1662 and
-4.1145, respectively. The values of the mean and the median of different use of leverage indicate that the optimal leveraged investment shows the greatest performance
among the approaches.
5.2. Experiment
Item
GM (l ) = GM (lgbm ) GM (l ) = GM (1)
P-value
0.0024
1.1465x1010
Confidence [+0.0012; +0.0057] [+0.0878; +0.1586]
Interval
(P95%)
Null HyRejected
Rejected
pothesis
83
GM (l ) = GM (10)
0
[+14.8602 ; +19.3474]
Rejected
Table 5.2: T-Test of the difference between the log of the end of period equity return of optimally leveraged investment and geotmric Brownian motion leveraged
investment (GM (l ) = GM (lgbm )); the difference between the log of the end of period equity return of optimally leveraged investment and unleveraged investment
(GM (l ) = GM (1)); and the difference between the log of the end of period equity return of optimally leveraged investment and excessive leveraged investment
(GM (l ) = GM (1)).
From Table 5.2, the null hypothesis that the difference between the end of period
equity returns of the optimally leveraged investments and the excessively leveraged
investments is null is rejected with a probability of 95%; and the null hypothesis
that the difference between the end of period equity returns of the optimally leveraged investments and the unleveraged investments is null is also rejected with a
probability of 95%. This fact, combined with the confidence interval with positive
values in both tests, demonstrates that the use of optimal level of leverage results
in a statistically-significant improvement in investment performance.
Figure 5.7 shows the boxplot of the series of the log of the end of period equity
return. From this figure, note that the performance of the optimally leveraged is
superior to the geometric Brownian motion leveraged, unleveraged and excessively
leveraged investment.
From the experiment, it is possible to obtain three different results. Firstly, the
average value of the log of the end of period equity returns of geometric Brownian
motion leveraged investments is 14.26%. From Table 5.2, the confidence interval of
the difference between the optimally leveraged investments and geometric Brownian
motion leveraged investments is between +0.0012 and +0.0057, which indicates
interval of the estimated improvement between +0.84% and +4.00%. Therefore,
the improvement of the use of the optimally leveraged investments is aproximately
Log of End of Period Return
84

Methods
1.5
1.5
10
0.5
0.5
10
20
0
0
30
0.5
1 Opt
0.5
GBM
40
Opt
Unl
50
Opt
Exc
Figure 5.7: The boxplot of the log of the end of period equity return of the optimally
leveraged vs. the geometric Brownian motion leveraged investment; the boxplot
of the log of the end of period equity return of the optimally leveraged vs. the
unleveraged investment; and the boxplot of the log of the end of period equity
return of the optimally leveraged vs. the excessively levearaged investment.
between 1.1 and 1.3 times with a probability of 95%.

Secondly, the average value of the log of the end of period equity returns of
unleveraged investments is 0.0311. This indicates that the estimated end of period return is 3.16%. From Table 5.2, the confidence interval of the difference
between the optimally leveraged investments and unleveraged investments is between +0.0878 and +0.1586, which indicates interval of the estimated improvement
between +9.18% and +17.19%. Therefore, the improvement of the use of the optimally leveraged investments is aproximately between 3.9 and 6.4 times with a
probability of 95%.
Finally, the average value of the log of the end of period equity returns of excessively leveraged investments is -16.9495. This indicates that the estimated end
of period return is -100%. From Table 5.2, the confidence interval of the difference between the optimally leveraged investments and unleveraged investments is
between +14.86 and +19.35, which indicates interval of the estimated improvement
extremely huge over 108 . Due to the fact that the excessively leveraged investment
results in default on average, the improvement of the optimally leveraged invest-
5.3. Discussion
85
ments is not possible to be calculated. However, it certainly is superior because as

I showed in the experiment, any result is superior to default.
5.3
Discussion
In this section, I discuss the result of the experiment in Section 5.2. Leverage is
concave in the geometric mean of the historical returns (see chapter 3), hence, there
is some level of leverage that maximises the geometric mean. In Section 4.4, I
proposed a numerical method in order to find optimal level of leverage. I assumed
that the main objective of the investor is to maximise the end of period equity return
(Williams 1936; Latane 1959).
In Section 5.2, I back-tested the ability of an investment employing the optimal
level of leverage using numerical methods to show a performance superior to geometric Brownian motion leveraged, unleveraged and excessively leveraged investment,
i.e., to show end of period of the equity returns superior to the geometric Brownian
motion leveraged, unleveraged and excessively leveraged investments.
There are three different results from the back-testing. The first result is that
optimal level of leverage results in a superior investment performance to geometric
Brownian motion leveraged investments. Furthermore, considering that the average
value of the end of period equity return of the geometric Brownian motion leveraged
investments is +14.26%, and that the confidence interval of the difference between
the end of period equity returns of optimally leveraged and geometric Brownian
motion leveraged investments is between +0.84% and +4.00%; the end of period
and 1.3 times the end of period equity return of the geometric Brownian motion
leveraged investments with a statistical probability of 95%.
The second result is that optimal level of leverage results in a superior investment
performance to unleveraged investments. Furthermore, considering that the average

Methods
86
value of the end of period equity return of the unleveraged investments is +3.16%,
and that the confidence interval of the difference between the end of period equity
returns of optimally leveraged and unleveraged investments is between +9.18% and
+17.19%; the end of period equity return of the optimally leveraged investments
is approximately between 3.9 and 6.4 times the end of period equity return of the
unleveraged investments with a statistical probability of 95%.
Finally, The third result is that optimal level of leverage results in a superior
investment performance to excessively leveraged investments. Considering that the
average value of the end of period equity return of the excessively leveraged investments is -100%, i.e., default, it is not possible to calculate the improvement
caused by the use of optimal level of leverage using numerical methods. However,
the improvement exists because any result is better than default.
Therefore, the intelligent use of leverage cannot be ignored because the optimal level of leverage using numerical methods result in a superior performance to
geometric Brownian motion leveraged, unleveraged and excessively leveraged investments.
5.4
Summary
In this chapter, I back-tested the optimal level of leverage using numerical methods.
The advantage of the back-testing is the use empirical evidence to test the ability
of the optimal level of leverage using numerical methods to improve the investment
performance. I compared the investment performance of the optimal leveraged investments to the geometric Brownian motion leveraged, the unleveraged and the
excessively leveraged investments. I assumed that the excessive level of leverage is
the level of leverage of ten because, in Figure 5.6, there was no average value of
optimal level of leverage which is superior to this value, ten.
I randomly selected 103 times, one component of the S&P 500 Index and one
5.4. Summary
87
window period of 1250 days between 2000 and 2011. The window period is split
in two parts, one part with 1000 data and another part with 250 data. The first
part serves to calculate the optimal level of leverage and the second part serves to
back-test the use of the optimal level of leverage calculated using numerical methods.
There are three different results from the experiment. Firstly, the performance
after employing the optimal level of leverage using numerical methods is approximately between 1.1 and 1.3 times the performance of the geometric Brownian motion
leveraged investment, with a probability of 95%. Secondly, the performance after
employing the optimal level of leverage using numerical methods is approximately
between 3.9 and 6.4 times the performance of the unleveraged investment, with a
probability of 95%, that is, the investor who uses the optimal level of leverage has
the expectation to triplicate or more their equity returns compared to unleveraged
investment. Finally, thirdly, the use of the optimal level of leverage using numerical
methods is superior to the excessively leveraged investment because the usage of the
excessively leveraged investment results in default.
The results of the back-testing show that, compared to geometric Brownian
motion leveraged, unleveraged and excessively leveraged investment, the optimal
level of leverage using numerical methods improves the investment performance.
Thus, the appropriate level of leverage is an important parameter to be taken into
account when the objective is to maximise the end of period equity return.
The contribution of this chapter is to show that the model proposed in Chapter 4
allows to reach to a superior performance to different approaches of leverage, under
an analysis which uses historical data from all components of the S&P 500 index. By
performing this back-testing, I am able to avoid making any assumptions about the
distribution of returns. This is in contrast to existing studies which simply assume
that returns are normally distributed, and do not evaluate their performance using
empirical data (Kelly 1952; Rotando and Thorp 1992, and Peters 2010).
In the next chapter, I introduce a leveraged component of agents decision making
into an agent-based model of a financial market.
Chapter 6
Agent-Based Modelling of
Optimal Leverage Model using
Numerical Methods
In this chapter, I introduce a leveraged component of agents decision making into
an agent-based model of a financial market. Previous models have used expected
utility optimisation as a framework for agents trading decisions. The motivation
of this chapter is that there are two different issues on the experiment of leverage.
Firstly, previous studies have shown that similar strategies can perform well when
tested against theoretical models of asset price processes such as geometric Brownian
motion (Peters 2010). However, the former approach fails to account for phenomena
such as non-Gaussian return distributions which are observed in real markets.
Secondly, in Chapter 5, I back-tested the optimal level of leverage using numerical methods against historical empirical price data. However, this cannot take
into account how other participants in the market would likely respond to a newly
introduced trading strategy; i.e., this ignores the existence of market impact.
In order to account for these issues, I test my strategy using an existing agentbased model of financial markets (Iori and Chiarella 2002) which has been shown to
replicate many of the statistical features observed in empirical financial time-series
Chapter 6. Agent-Based Modelling of Optimal Leverage Model using Numerical

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data. I analyse my strategy by simulating its behaviour under this model, and find
that the key variable that influences its performance is the size of the market.
of this chapter. In Section 6.2, I present the existing platforms in the literature to
simulate agent-based models. In Section 6.3, I describe the model that I employed
to test the ability of optimally leveraged investments to improve the investment
performance using agent-based modelling. In Section 6.4, I present the results of
the experiment using an agent-based model that compare the optimally leveraged
investments both to unleveraged and excessively leveraged investments. In Section
6.5, I discuss the implications of the results of the experiment presented in Section
6.4. Finally, in Section 6.6, I present the summary and the contribution of this
chapter.
6.1
Introduction
In Section 2.6, I reviewed the literature on agent-based modelling, and described that
agent-based modelling consist in a set of tools that model individual agent behaviour
and its consequences to the system. These tools allow designing heterogeneous
agents in the same system. Consequently, they also allow us to analyse investor
(agent) behaviour and its consequence to the financial market (system) (LeBaron
2000; Iori and Chiarella 2002; and Lo and MacKinlay 2001).
Agent-based modelling allows us to replicate the stock market artificially in order
to make controlled experiments and simulations (Chakraborti et al. 2011). One of
the advantages of this artificial environment is the control of every aspect of the
simulation, including the individual agent behaviour (Lux and Marchesi 2001; and
Iori and Chiarella 2002). For example, using agent-based modelling, it is possible
to run experiments in high-frequency environment taking into account the market
impact.
Iori and Chiarella (2002) introduce an agent-based model in which they assume
6.1. Introduction
91
that each agent has zero-intelligence in leverage since each agent can only trade one
unit of stock at a time. In order to introduce leverage intelligence in agent-based
modelling, Iori and Chiarella (2009) propose an extension to Iori and Chiarella
(2002) in which agents decide the volume according to a utility function. The
difference among the agents relates to their risk profile: the higher the level of
risk-aversion, the smaller the quantity ordered.
In terms of leverage, in Section 2.3, I highlighted that there is a considerable debate in the literature on the investors objective. There are two different approaches,
the mean-variance approach and the geometric mean approach. The mean-variance
approach advocators argue that the investors objective is to maximise the utility
function according to her risk-profile (Markowitz 1952), and the geometric mean approach advocators argue that the investors objective in the multi-period framework
is to maximise the geometric mean (Williams 1936).
Furthermore, in Section 2.5, I described the three analytical models existing in
the literature to calculate the level of leverage that maximises the geometric mean
of the historical returns. The first model is the Kelly Criterion (Kelly 1956), which
assumes a discrete number of possible outcomes. The second model is the Rotando
and Thorp model (Rotando and Thorp 1992), which incorporates continuous outcomes, but respects the Kelly original insights. Finally, the third model is the Peters
Model (Peters 2010), which assumes that the prices follow a geometric Brownian
motion.
These three analytical models assume a normal distribution of the returns that
undermines the probability of extreme returns (Cont 2001). For this reason, in
Chapter 4, I proposed the use of numerical methods in order to calculate the optimal level of leverage instead of the analytical models. The main advantage of the
numerical methods is that I can relax the assumption of normal distribution of the
returns.
In contrast to Iori and Chiarella (2009), in this experiment, I propose the use of
geometric mean in order to decide the quantity to trade instead of the use of utility

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Methods
function and risk-profile. The reason is that I assume that in the multi-period
framework, the investment performance is measured by the end of period return
which is in line with the geometric mean approach (Kelly 1956; Latane 1959). Hence,
I introduce the optimal level of leverage using numerical methods in an order-driven
model (Iori and Chiarella 2002).
The objective of this chapter is to apply agent-based modelling to test the hypothesis that the use of optimal level of leverage model has the ability to improve
individual agent performance in a high-frequency environment. In Chapter 5, using
back-testing and the series of the historical price of the components of S&P 500 between 2000 and 2010, and assuming that there was no trading system and that the
orders were market orders, I demonstrated that optimal level of leverage using numerical methods has the ability to improve investment performance in a multi-period
framework of 250 days. However, due to the use of historical data, back-testing assumes that agents are exogenous to the system and there is no market impact; and
because of the assumption of market orders, back-testing also considers that every
order is matched without facing any competition per trade.
The assumption of no market impact is very strong particularly in the highfrequency environment because there is a negative correlation between the frequency
of the strategy and the market impact, i.e., the higher the frequency the lower the
market impact. For this reason, I use agent-based modelling instead of back-testing
because I assume that the agents behaviour has consequences in the market; and
by using limit-orders, I also consider that there is competition between orders to be
matched.
Similar to Chapter 5, I select three agents that trade according to different leverage approaches in order to decide the quantity: a) the unleveraged agent who orders
a quantity to maintain the level of leverage equals to 1; b) the optimally leveraged
agent who applies the optimal level of leverage using numerical methods (see chapter
4) in order to decide the quantity; and, finally, c) the excessively leveraged agent
who orders a quantity to maintain the level of leverage equals to 10.
6.2. Platform
93
However, differently of Chapter 5, I do not consider the geometric Brownian

motion leveraged approach. The reason is that this approach requires the calculation
of the mean and the variance. This requires fixed time-period of the data which is
not appropriate to enforce the experiment because one of the assumptions of the
model with no market impact is free time-period.
In order to simulate in different competitive market environments, I run experiments under three different treatments to investigate the ability of optimal level of
leverage to improve the investment performance regarding the size of the market in
terms of agents, with 10, 100 and 1000 agents. The reason is that I assume that the
size of the market is positively correlated to the level of competition for trades, i.e.,
the greater the size of the market the higher the level of competition. The results
show that the use of optimal level of leverage improves the agent performance only
in a small market with 10 agents.
In the literature on agent-based modelling, authors have been proposing Artificial
Stock Market experiments in order to analyse the financial market in the macro-level
(LeBaron 2000; Iori and Chiarella 2002; and Lo and MacKinlay 2001). However, to
the best of my knowledge, there are no studies proposing experiments in order to
analyse the impact of leverage at the level of individual agents. Thus, I propose a
new use of an Artificial Stock Market that is the analysis of the consequences of the
trading behaviour of an individual agent instead of the consequences of the agents
behaviour to the financial market.
In the next section, I present the existing platforms in the literature to simulate
agent-based models.
6.2
Platform
To the best of my knowledges, the existing platforms in the literature to simulate

agent-based models are StarLogo (Resnick 1996), Repast (Collier 2003), NetLogo
(Sklar 2007), JABM (Java Agent-Based Modelling) (Phelps 2012) and JASA (Java

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Methods
Auction Simulation API) (Phelps 2007). StarLogo is a programming modeling environment designed to model decentralized system such as Macroeconomics patterns with micro-fundamentals (Resnick 1996). Repast is a platform to simulate
the interaction of agents and to control its interaction written in Java programming
language. Its advantage is that the agents behaviour is controlled according to a
schedule. Thus, different agents acts in different moments of time instead of acting
each agent at the same time (Collier 2003). The NetLogo is an agent-based package
which is the evolution of the StarLogo (Resnick 1996). It allows the definition of
heterogeneous agents and simulate the interaction between each other.
For the propose of this thesis, I use the Java Auction Simulation API (JASA)
(Phelps 2007) which is a extension of the Java Agent-Based Modelling (JABM)
(Phelps 2012). JABM is a toolkit to make agent-based model simulation, and JASA
is its extension to make agent-based computational finance simulation. According
to Phelps (2007), this platform is an auction simulator written in Java which accepts
a large number of auctions with different types of agents and ability to experiment
wide variety of trading strategies. Furthermore, he argues that it has many features
that facilitate the development of multi-agent system simulations. For example,
agents and individual agents can be represented by classes and objects, respectively;
and they can communicate between each other.
There are two reasons for the use of JASA. Firstly, JASA and JABM are a
100% Java platform, which facilitates the introduction of JAVA extensions in this
platforms. And, secondly, JABM and JASA are an open source software, which
allows me to control each code of the original script and modifies it to my purposes.
In the next section, I describe the model that is employed to test the ability
of optimally leveraged investments to improve the investment performance using
agent-based modelling.
6.3. Model
6.3
95
Model
In this section, I extend the original model introduced Iori and Chiarella (Iori and
Chiarella 2002) which was reviewed in Section 2.6, by allowing the agents to specify
the quantity of their orders, rather than assuming that all orders have a quantity
of 1; and also by introducing three additional agents into the population which use
different levels of leverage. The first agent uses the optimal level leverage using
numerical methods (see Chapter 4) to calculate the quantity in the order:
max
l
[1 + kt (l)] T 1
where l is the level of leverage, kt is the equity return. Thus, since pt qt = Kt lt ,

where Kt is the current equity, pt is the price at the moment t, qt is the current
quantity of the position at the moment t, the quantity to be held by the optimal
leveraged agent is:
qtopt =
Kt l
pt
where qtopt is the quantity ordered by the optimal leveraged agent, and l is the
optimal level of leverage.
The second agent targets the level of leverage of 1, i.e., the agent is unleveraged.
Thus, the quantity to be hold by the unleveraged agent is:
qtunl =
Kt
pt
where qtunl is the quantity ordered by the unleveraged agent.

Finally, the third agent orders sufficient quantity in order to maintain the agents
level of leverage at 10. Thus, the quantity to be hold by the excessive leveraged agent
is:
qtexc =
10Kt
pt

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Methods
where qtexc is the quantity ordered by the excessively leveraged agent.
In the next section, I present the results of the experiment using agent-based
modelling.
6.4
Experiment
In this section, I present the results of the experiment using agent-based modelling
that compare the optimally leveraged investments to unleveraged and excessively
leveraged investments. The section is divided in two subsections. In the first subsection, I describe the methodology of the experiment. And, in the second subsection,
I present the results of the experiment.
6.4.1
Methodology
In this subsection, I describe the methodology of the experiment. I run three different treatments according to the number of artificial agents in order to verify the
ability of the optimally leveraged agent to outperform the unleveraged agent and
the excessive leveraged agent in different sizes of market. The number of agents in
the first treatment is 10, in the second treatment is 100, and in the third treatment
is 1000.
For each treatment, in order to avoid any preference for a particular trading
strategy, I randomly select three different agents who are empowered with leverage
behaviour in contrast to the remaining agents who continue to trade 100 units per
round. The selected agents are split between the optimally leveraged agent (l = l ),
the unleveraged agent (l = 1), and the excessively leveraged agent (l = 10).
Each simulation consists of 106 rounds. On each round, agents has a chance to
re-evaluate their previous order to modify or maintain it in the order book. Every
time that the price in the order to buy is superior or equals to the price in the
counterparty order to sell, the order and the counterpart order matches, a new
trade occurs, and the quantity traded is the quantity of the agent who is offering
6.4. Experiment
97
the least quantity. The remaining quantity of the agent who was offering the highest
quantity continues in the order book until the new match until an either a new match
occurs, or the agent modifies or cancels the order.
This is important to notice that, in a market with less agents, the chance of
a particular agent to re-evaluate the order increases. However, it does not mean
that the probability of a new order to be accepted increases. The reason is that
the re-evaluation is based on the agents trading strategy instead of the order book
position. For example, there are cases where the position of the new order in the
order book is inferior to the previous order which undermines the probability of
matching. Hence, I assume that there is no influence of the rate of re-evaluation on
the level of competition.
I run 100 simulations per treatment. On every simulation I record the end of
period return of the agents. Thus, on each treatment, I collect a set of 100 end of
period returns per agent. Using this data, I test the hypothesis that the optimally
leveraged agent outperforms the unleveraged agent, and test the hypothesis that the
optimally leveraged agent outperforms the excessively leveraged agent.
I use the T-test in order to test these hypotheses. In the first T-test, I test the
difference between the log of the ends of period returns of the optimally leveraged
agent and the ends of period returns of unleveraged agents. In the second T-test,
I test the difference between the log of the ends of period returns of the optimally
leveraged agents and the ends of period returns of unleveraged agents.
The experiment is run in JASA (JAVA Auction Simulation API) (Phelps 2007),
an application of JABM (JAVA for Agent-Based Modelling) (Phelps 2012).
6.4.2
Results
In this subsection, I present the results of the experiment with three different treatments regarding the size of the market. In the first treatment, the size of the market
is 10; in the second treatment, the size of the market is 100; and, finally, in the third

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Methods
treatment, the size of the market is 1000.
N = 10 Agents
In this treatment, the agent-based model contains 10 agents. Three of the agents
have the ability to order quantities different to 100 per round, which corresponds to
30% of the participants.
Item
Mean
Median
Minimum
Maximum
Standard Deviation
Skewness
Kurtosis
Average Number of Orders Executed
Opt
U nl
Exc
4.4552
0.0531
-7.5764
5.7238
2.4852
-7.4434
-11.3388 -12.2820 -10.3550
6.6596
7.2056
3.3390
2.9081
0.6590
4.2618
-0.07
-0.20
2.84
10.1306
1.7821
27.8044
1772.4
3644.8
1207.9
Table 6.1: Statistical analysis of the log of the ends of period returns, N = 10 agents.
Opt = optimally leveraged, Unl = unleveraged and Exc = excessively leveraged.
Item
Confidence Interval
P-value
Null Hypothesis
Opt U nl
[3.0159 ; 5.7882]
8.2212x109
Rejected
Opt Exc
[11.1622 ; 12.9009]
4.2326x1048
Rejected
Table 6.2: T-test results between the log of the end of period return of the optimally
leveraged agent (Opt) and the unleveraged agent (Unl); and the optimally leveraged
agent and the excessively leveraged agent (Exc). N = 10 agents.
From the treatment with 10 agents, I obtain the following results. Firstly, from
Table 6.1, the average number of orders executed of optimally leveraged, unleveraged and excessively leveraged agent are 1772.4, 3644.8 and 1207.9, respectively.
Secondly, Figure 6.1 shows the logs of the ends of period returns of the optimally
leveraged and excessively leveraged agents. From Table 6.2 and from Figure 6.2,
the null hypotheses of equality of the ends of period returns between the optimally
leveraged agent and the unleveraged agent, and between the optimally leveraged
agent and the excessively leveraged agent are rejected. Furthermore, due to the
positive values of the confidence interval, the end of period return of the optimally
6.4. Experiment
99
Optimally Leveraged
20
0
20
0
20
40
60
Unleveraged
80
100
20
40
60
Excessively Leveraged
80
100
80
100
20
0
20
0
20
0
20
0
20
40
60
Figure 6.1: The plot of the log of the end of period returns of leveraged agents,
N=10 agents.
10
Optimal
Unleveraged
Excessive
N=10 agents.

100
Methods
leveraged agents is superior to the end of period return of the unleveraged agent
and to the end of period return of the excessively leveraged agent with a probability
of 95%, in both cases.
N = 100 Agents
3% of the participants.
Item
Mean
Median
Minimum
Maximum
Standard Deviation
Skewness
Kurtosis
Opt
U nl
Exc
-0.2892 -1.3826 -5.3485
2.5879 0.6952 -7.5082
-9.4852 -9.3668 -11.0809
4.6248 7.3715
4.9791
5.1023 4.9885
4.8125
-0.7781 -0.2663 1.2220
1.7296 1.6569
2.7902
172.9
150.3
173.3
Table 6.3: Statistical analysis of the log of the ends of period returns, N = 10o agents.
Opt = optimally leveraged, Unl = unleveraged and Exc = excessively leveraged.
Item
Confidence Interval
P-value
Null Hypothesis
Opt U nl
Opt Exc
[ -0.3578 ; 2.5516] [3.6257 ; 6.4618]
0.1378
2.3529x1010
Accepted
Rejected
Table 6.4: T-test results between the log of the end of period return of optimally
leveraged agent (Opt) and unleveraged agent (Unl) and optimally leveraged agent
and excessively leveraged agent (Exc). N = 100 agents.
From the treatment with 100 agents, I obtain the following results. Firstly, from
Table 6.3, the average number of orders executed of optimally leveraged, unleveraged
and excessively leveraged agent are 172.9, 150.3 and 173.3, respectively. Secondly,
Figure 6.3 shows the logs of the ends of period returns of the optimally leveraged and
excessively leveraged agents. Finally, from Table 6.4 and from Figure 6.2, the null
hypothesis of equality of the end of period return between the optimally leveraged
and the unleveraged agent is accepted. However, the null hypothesis of equality
6.4. Experiment
101
Optimally Leveraged
20
0
20
0
20
40
60
80
100
80
100
80
100
Unleveraged
20
0
20
0
20
40
60
20
0
20
0
20
40
60
Iterations
Log of the End of Period Return
N=100 agents.
10
Optimal
Unleveraged
Excessive
Figure 6.4: The boxplot of the log of the end of period returns of leveraged agents,
N=100 agents.

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Methods
of the end of period return between the optimally leveraged and the excessively
leveraged agent is rejected and, due to the positive confidence interval, the end of
period return of the optimally leveraged agent is superior to the end of period return
of the excessively leveraged agent with a probability of 95%.
N = 1000 Agents
0.3% of the participants.
Item
Mean
Median
Minimum
Maximum
Standard Deviation
Skewness
Kurtosis
Opt
-2.6577
-0.0207
-9.8221
6.8663
4.8286
-0.0120
1.4469
7.7
U nl
-1.7049
0.0006
-11.4798
7.7735
5.2910
-0.1815
1.6598
15.8
Exc
-4.3978
-7.2105
-11.2290
6.3916
5.1774
0.6895
1.8010
14.1
Table 6.5: Statistical analysis of the log of the ends of period returns, N = 1000
agents. Opt = optimally leveraged, Unl = unleveraged and Exc = excessively leveraged.
Item
Confidence Interval
P-value
Null Hypothesis
Opt U nl
[-2.4527 ; 0.5470]
0.2104
Accepted
Opt Exc
[0.4991 ; 2.9811]
0.0065
Rejected
Table 6.6: T-test results between the log of the end of period return of optimally
leveraged agent (Opt) and unleveraged agent (Unl) and optimally leveraged agent
and excessively leveraged agent (Exc). N = 1000 agents.
From the treatment with 1000 agents, it is possible to obtain the following results. Firstly, from Table 6.5, the average number of orders executed of optimally
leveraged, unleveraged and excessively leveraged agent are 172.9, 150.3 and 173.3,
respectively. Secondly, Figure 6.3 shows the logs of the ends of period returns of
the optimally leveraged and excessively leveraged agents. Finally, similar to the
6.4. Experiment
103
Optimally Leveraged
10
0
10
0
20
40
60
80
100
80
100
80
100
Unleveraged
20
0
20
0
20
40
60
20
0
20
0
20
40
60
Iterations
N=1000 agents.
10
Optimal
Unleveraged
Excessive
N=1000 agents.

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treatment with 100 agents, from Table 6.6 and Figure 6.6, the null hypothesis of
equality of the end of period return between the optimally leveraged and the unleveraged agent is accepted. However, the null hypothesis of equality of the end of
period return between the optimally leveraged and the excessively leveraged agent is
rejected and, due to the positive confidence interval, the end of period return of the
optimally leveraged agent is superior to the end of period return of the excessively
leveraged agent with a probability of 95%.
In the next section, I discuss the implication of the results of this experiment.
6.5
Discussion
In this section, I discuss the implication of the results of the experiment presented in
Section 6.4. The results of the experiment show that in an agent-based model with
10 agents, where 30% of them are empowered with leverage intelligence, the optimal
leveraged agent outperforms unleveraged agent and excessive leveraged agent with
statistical probability of 95%. In an agent-based model with 100 agents, where 3% of
them are empowered with leverage intelligence, the optimally leveraged agent outperforms the excessively leveraged agent but does not outperform unleveraged with
statistical probability of 95%. Finally, in an agent-based model with 1000 agents,
where only 0.3% of them are empowered with leverage intelligence, similar to an
agent-based modelling with 100 agents, the optimally leveraged agent outperforms
the excessively leveraged agent but does not outperform unleveraged with statistical
probability of 95%.
The use of optimal level of leverage improves the agents performance in the
market with 10 agents. However, the analysis of the results suggest that the ability
of the optimal level of leverage to improve the individual agents performance is
positively correlated with the size of the market; the greater the number of agents,
the lower the agents ability.
These results highlight questions about the importance of the market size. For
6.6. Summary
105
example, is the size of the market interesting to the individual agent regardless of
the agents trading strategy or leverage approach? Assuming that there is positive
correlation between the size and efficiency of the market, the results suggest that
there could be a negative correlation between market efficiency and the ability of
optimal level of leverage to improve the individual trading system performance,
because if the market is efficient the returns are expected to be so small that there
is no winner or loser strategy or approach on leverage.
6.6
Summary
In this chapter, I applied agent-based modelling to test the hypotheses that, in

the high-frequency environment, compared to unleveraged and excessive leveraged
agent, the use of an optimal level of leverage model using numerical methods has
the ability to improve individual agents investment performance.
The results of the experiment suggest that the ability to use of the optimal level
of leverage using numerical methods to improve investment performance depends on
the size of the market; this is not a guarantee of the improvement of the investment
performance regardless of the market condition and the trading strategy. Furthermore, the results also suggest that there is a negative correlation between the ability
of the optimal level of leverage using numerical methods to improve the investment
performance and the size of the market.
The contribution of this chapter is the introduction of a leveraged component of

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Methods
There are two different motivations of this chapter. Firstly, previous studies have
proposed models to optimise the level of leverage using analytical models that requires the assumption of no extreme returns (Kelly 1956; Rotando and Thorp 1992;
and Peters 2010). However, the former approach fails to account for phenomena
such as non-Gaussian return distributions which are observed in real markets, and
consequently, these models could not be experimented in a high-frequency environment. In order to solve this issue, in Chapter 4, I proposed the optimization of the
level of leverage using numerical methods instead of analytical model. This allowed
to run the experiment to test the ability of an optimal level of leverage model to
improve individual agents investment performance.
Secondly, agent-based modelling allows me to experiment the employment of
the optimal level of leverage using numerical methods in a totally controlled environment. Consequently, this allows me to simulate the high-frequency results.
Therefore, this serves to test the ability of optimal leverage models to improve the
investment performance in a more reliable high-frequency framework because it relaxes the assumption of no market impact, i.e., the assumption that the behaviour
of the leveraged agent does not influence the market, and it is independent of the
market size. In Chapter 5, I back-tested the optimal level of leverage using numerical
methods against historical empirical price data. Consequently, I assume no market
impact. However, this is a particular strong assumption for the high-frequency environment because of the negative correlation between the frequency of the data and
the market impact, i.e., the more frequent the data, the higher the market impact.
In the next chapter, I conclude the thesis. I present the summary of the thesis
and propose a series of future research which could represent an advance of this
work.
Chapter 7
Conclusion and Future Work
Leverage plays a very important role in the financial markets. It has the ability
to expand returns and, consequently, profits and end of period wealth. However,
the connection between leverage and cumulative return is not linear. High level of
leverage does not necessary means high level of cumulative equity return. In fact,
an excessive level of leverage increases the risk of default. Hence, studies of leverage
are relevant because this tool can encourage irrational behaviour which can impact
the market and can lead the investor to ruin. In order to comprehend leverage as a
whole, it is necessary to comprehend the investors use of leverage besides its impact
on the financial market.
In this thesis, I proposed a new method to calculate the optimal level of leverage
which uses numerical methods instead of analytical methods. This was not feasible
without advances in computing technology. Furthermore, I tested the ability of the
method to improve the individual investment performance employing two different
approaches: back-testing and agent-based modelling. Back-testing allows me to test
the optimal level of leverage using numerical methods using empirical evidence, and
agent-based modelling allows me to test the optimal level of leverage using numerical
methods in a totally controlled environment.
This chapter is structured as follows. In Section 7.1, I present the summary
of this thesis. And, in Section 7.2, I discuss the possible future research from this
108
Chapter 7. Conclusion and Future Work
work.
7.1
Summary of the Work
This thesis consists in seven chapters, including the current one. Chapter 1 and 2,
are the introduction to the thesis and the background of the leverage and agentbased modelling, respectively.
In Chapter 1, I introduced the motivation, the research objectives and the approach, and the contribution of thesis. In the motivation, I described the relevance
of the studies of leverage for the individual investments. Additionally, I highlighted
that there are three main reason for the studies of leverage. Firstly, recent studies
about leverage demonstrate that excessive level of leverage is considered irrational
behaviour (Geanakoplos 2009; Thurner, Farmer, and Geanakoplos 2011). Secondly,
the equity return formula has two components: the stock return and the level of
leverage, and the level of leverage is linear in the equity return formula (Peters
2010). Thirdly, leverage can lead the investor to ruin. I demonstrated that the
existing analytical models in the literature to optimize the level of leverage assumes
a normal distribution of the financial returns and it undermines the risk of default.
One of the research objectives of this thesis was to design a numerical method to
calculate the optimal level of leverage that allows the relaxation of the assumption
of normal distribution of the series of financial returns, and to test the ability of
this method to improve investment performance. The approach that I took was
to assume that the agents objective is to maximise the end of period return, and
compare the individual end of period equity return under three different levels of
leverage: the unleveraged (level of leverage = 1), optimally leveraged, excessively
leveraged investment (level of leverage = 10).
There are three specific contributions of this thesis. The first contribution is to
show that a commonly-used proxy of the geometric mean, which is widely used in
the current literature, fails to accurately estimate leveraged returns. The second
7.1. Summary of the Work
109
contribution is the introduction of a novel trading strategy which uses numerical

methods in order to calculate the optimal level of leverage. Moreover, I show that
my trading strategy exhibits superior performance to a strategy which does not use
leverage, under an analysis which uses historical data from all components of the
S&P 500 index. Finally, the third contribution is the introduction of a leveraged
component of agents decision making into an agent-based model of a financial market. Previous models have used expected utility optimisation as a framework for
agents trading decisions.
In Chapter 2, I presented the literature review of this thesis. Firstly, I reviewed
the literature on leverage. Secondly, I reviewed the literature on the models to
estimate the returns because in Chapter 3, I discussed the ability of that models to
be employed to estimate the leveraged returns. Thirdly, I reviewed the literature of
the investors objective because in Chapter 4, I assumed that the investors objective
is to use the geometric mean approach in order to optimize the level of leverage.
Fourthly, I presented the existing models to optimize the level of leverage. Finally,
I reviewed the literature of agent-based modelling because in Chapter 6, I employed
this environment to test the ability of optimal level of leverage to improve the
investment performance.
Chapters 3 to 6 presented the research contributions of the thesis. Firstly, in
Chapter 3, I tested the ability of the proxy of the geometric mean to estimate leveraged returns of the returns on leverage. In the literature, there is an approximation
of geometric mean that employs the arithmetic average and the variance of the stock
return (Parramore and Watsham 1997). This formula is widely used because it facilitates a closed-form solution of the analytical model. This approximation assumes
that the series of financial returns are normally distributed. However, leverage has
the ability to expand the equity return and consequently, increases extreme returns.
Hence, this approximation underestimates extreme returns and, consequently, underestimates the risk of default.
I tested the use of this formula for leveraged equity returns instead of stock
110
returns. Thus, I tested the hypothesis that the proxy of the geometric mean represents the geometric mean of the leveraged returns. In order to perform the test,
I simulated the investment in the components of the S&P 500 Index on different
windows periods between 2000 and 2011 using different levels of leverage with values
between 1 and 10.
The result is that even though the proxy is accepted to calculate the geometric
mean of unleveraged equity returns, it is rejected to calculate the geometric mean of
leveraged equity returns. The proxy has the advantage of allowing the calculation
of the geometric mean of the stock return in a closed-form solution. However, stock
return is only one of the parameters of the equity return, the other parameter is the
level of leverage.
Thus, the contribution of Chapter 3 is to show that a commonly-used proxy of
the geometric mean, which is widely used in the current literature, fails to accurately
estimate leveraged returns. This proxy uses the arithmetic average and the variance
of the stock returns (Parramore and Watsham 1997). However, this proxy assumes
that returns can be characterised by the first two moments and ignores the fat-tailed
return distributions that are observed in actual empirical data (Cont 2001).
Secondly, in Chapter 4, I proposed a numerical method in order to calculate the
optimal level of leverage. The advantage of the use of numerical methods is that, in
contrast to the analytical models existing on the literature, these methods do not
assume that the series of financial returns are normally distributed.
I tested the hypothesis that numerical methods yield superior geometric mean to
the geometric Brownian motion. In order to do that, I calculated the optimal level
of leverage using numerical methods and by using geometric Brownian motion of 104
series of daily returns of the components of the S&P 500 Index. In the experiment,
the stock, the length of the series and the window period are randomly selected. The
result is that the numerical methods yield superior geometric mean of the series of
historical equity returns to geometric Brownian motion, even though when it shows
inferior level of leverage.
111
Similar to Chapter 3, the results of the experiment in Chapter 4 showed the advances caused by the use of numerical methods in leveraged models. For this reason,
I argue that the proxy and the analytical models used to calculate the unleveraged
equity returns cannot be directly used to calculate the leveraged equity returns because the proxy and the models assume that the returns are normally distributed,
ignores the presence of fat-tails and, consequently, underestimates extreme returns
present on the leveraged investments.
Thus, the contribution of Chapter 4 is the introduction of a novel trading strategy which uses numerical methods in order to calculate the optimal level of leverage. Previous studies have proposed analytical models in order to calculate the
optimal level of leverage. However, these models assume that returns are normally
distributed (Kelly 1952; Rotando and Thorp 1992, and Peters 2010). By using numerical methods in order to optimise the level of leverage, I am able to avoid this
assumption and hence avoid under-estimating extreme returns (Cont 2001).
Thirdly, in Chapter 5, using the historical price of the components of the S&P
500 Index, I back-tested the leveraged investment using the optimal level of leverage
using numerical methods. The hypothesis is that optimal leveraged investment
outperforms the geometric Brownian motion leveraged investment, the unleveraged
investment and the excessively investment.
There are three different results from the back-testing. The first result is that
optimal level of leverage results in a superior investment performance to geometric
Brownian motion leveraged investments. Furthermore, considering that the average
value of the end of period equity return of the geometric Brownian motion leveraged
investments is +14.26%, and that the confidence interval of the difference between
the end of period equity returns of optimally leveraged and geometric Brownian
motion leveraged investments is between +0.84% and +4.00%; the end of period
and 1.3 times the end of period equity return of the geometric Brownian motion
leveraged investments with a statistical probability of 95%.
112
The second result is that the null hypothesis of the equality between the series
of the end of period equity return of the optimally leveraged and the unleveraged
investment is rejected. Furthermore, considering that the average value of the end of
period equity return of the unleveraged investments is +3.16%, and the confidence
interval of the difference of the end of period equity returns is between +9.18% and
+17.19%; the end of period equity return of the optimally leveraged investments
is approximately between 3.9 and 6.4 times the end of period equity return of the
unleveraged investments with a statistical probability of 95%.
Finally, the third result is that the null hypothesis of the equality between the
series of the end of period equity return of the optimally leveraged investment and
the excessively leveraged investment is also rejected. Considering that the average
value of the end of period equity return of the excessively leveraged investments is
-100%, i.e., default, it is not possible to calculate the improvement caused by the
use of optimal level of leverage using numerical methods.
The results of the back-testing showed that, compared to geometric Brownian
motion leveraged, unleveraged and excessively leveraged investment, the optimal
level of leverage using numerical methods improves investment performance. Thus,
the appropriate level of leverage is an important parameter to be taken into account
when the objective is to maximise the end of period equity return.
The contribution of Chapter 5 is to show that my trading strategy (see Chapter
4) exhibits superior performance to a strategy which does not use leverage, under an
analysis which uses historical data from all components of the S&P 500 index. By
performing this back-testing, I am able to avoid making any assumptions about the
distribution of returns. This is in contrast to existing studies which simply assume
that returns are normally distributed, and do not evaluate their performance using
empirical data (Kelly 1952; Rotando and Thorp 1992, and Peters 2010).
Finally, in Chapter 6, I employed an agent-based model in order to experiment
with the use of the optimal level of leverage in a totally controlled environment. I
introduced three leveraged agents regarding their approach of leverage, the optimal
113
level of leverage using numerical methods, the unleveraged and the excessive level
of leverage, in an order-driven model proposed by (Iori and Chiarella 2002). Then,
I simulated it regarding to three different sizes of market, 10, 100 and 1000 agents
in the JASA platform (Phelps 2007).
The hypotheses are that the agent who uses the optimal level of leverage using
numerical methods outperforms the unleveraged agent and the excessive leveraged
agent. There are three different results from agent-based modelling experiment. In
the first treatment, in a market with 10 agents, both hypotheses are accepted. In
the second and in the third treatment, in a market with 100 and 1000 agents, respectively, the hypothesis that the optimal level of leveraged using numerical methods
improves the investment performance compared to is accepted excessively leveraged
investment; but compared to unleveraged agent the hypothesis that the optimal
level of leveraged using numerical methods improves the investment performance is
rejected.
The results of the experiment suggest that the ability of the use of the optimal
level of leverage using numerical methods to improve investment performance depends on the size of the market. It is not a guarantee of the improvement of the
investment performance regardless of the market condition and the trading strategy.
Furthermore, the results also suggest that there is a negative correlation between
the ability of the optimal level of leverage using numerical methods to improve the
investment performance and the size of the market.
The contribution of Chapter 6 is the introduction of a leveraged component of
114

There are two different motivations of this chapter. Firstly, the relaxing of the
assumption of no extreme returns (see Chapter 4) allowed me to test the ability of
an optimal level of leverage model to improve individual agents investment performance. Secondly, by introducing the optimal leverage models in the agent-based
Model, I could relax the assumption that the behaviour of the leveraged agent does
not influence the market and that the results are regardless the market size. As far
as I am aware of, there is no literature of optimal level of leverage in a high-frequency
environment. Furthermore, in the previous literature on the optimal leverage models, the agents behaviour and the market impact were ignored.
In this thesis, I have shown that the existing models to deal with leverage existing in the literature can be criticized because they assume that the series of financial
returns are normally distributed. This assumptions exists in order to allow the development of analytical models with closed-form solutions. However, since leverage
expands the equity returns, the assumption of normal distribution of the series of
financial returns could not be realistic. For this reason, I proposed a new model to
deal with leverage relaxing this assumption. The model proposed in this thesis uses
numerical methods instead of analytical methods in order to calculate the optimal
level of leverage.
In the next section, I discuss the possible future research from this work.
7.2
Future Work
The work of this thesis can be extended in three directions. The first direction
is the optimization of the level of leverage of a portfolio of stocks. This thesis
proposed a numerical methods to optimize the level of leverage of an investment in
a single stock. It could be interesting to investigate and experiment the possibility
of the use of numerical methods to optimize the level of leverage of a portfolio of
stocks. Estrada (2010) proposes an analytical model to calculate the optimal weight
7.2. Future Work
115
of a single stock in a portfolio of stocks. However, his model assumes the normal
distribution of the returns. Thus, it could be interesting experiments of the usage
of numerical methods in order to optimize the portfolio of stocks in terms of the
geometric mean, that relax the assumption of normal distribution of the returns.
The second direction is the use of different computational methods to optimize
the level of leverage, particularly, evolutionary computational algorithms such as
genetic algorithms and genetic programming. The evolutionary computation comes
from the Darwins idea of evolution, where survival depends on fitness. In the
context of solution fitting, the idea is to maintain a set of candidate solutions. Each
solution is evaluated for its fitness, which is measured in terms of their correctness
in classifying the data. The functions are then modified in an artificial environment
that mimics evolution, which eliminates weak individuals and allow fitter individuals
to pass their genetic material to latter generations (Tsang 2009). The difference
between genetic algorithm and genetic programming is that solutions are values
in the genetic algorithms and functions in the genetic programming. My insight
is that the calculation of the optimal level of leverage of a portfolio of stocks can
show different results of the existing results applying evolutionary computation in
its calculation. The reason is that the number of possible local optima in a portfolio
of stock is superior to this number in a single stock. Consequently, the chance of
have reach to a local optima in a portfolio of stock is superior to the chance in a
single stock.
Finally, the third field is the further development of agent-based modelling.
There are three topics that deserve further attention for the researchers. The first
topic is margin allowance. The current agent-based models do not consider the existence of margin limits and, consequently, do not take into account the possibility
of margin calls. Margin calls are orders input by the margin provider in order to
restore the margin allowance of the borrower. These kind of orders are irrational
because it was not input after the indication of some strategy, but input simply to
restore the margin. My intuition is that the existence of margin limits can modify
116
the results of the experiment, particularly, in the case of excessively level of leverage.
The second topic is the relevance of the current price to calculate the orders
price. The current model of Iori & Chiarella (2002) assumes that the order is Uniformly distributed between the current price and the valuated price. For example,
if the current price is $1000 and the valuated price is $1500, the probability that
the agents order to buy be $1001 and $1499 is the same. However, intuitively, it is
expected that the agent intend to proximate his orders price to the current price
as much as possible. Thus, new experiment with different statistical distributions
could be interesting.
Finally, the third topic is learning. In this thesis, I assumed no learning, it
means that agents does not modify their behaviour and their strategy along of the
experiment. The reason to assume no learning is that one of the objective of the
thesis was to introduce the optimal leverage models in the order-driven model (Iori
and Chiarella 2002). However, I argue that there is a considerable area of research
in learning, order-driven model and optimal leverage models.
LeBaron and Yamamoto (2007) introduce learning in the order-driven model.
Their modification is that the trading rules are repeatedly updated and adapted
via learning of the agents. The authors propose a learning process, where agents
imitate the strategy of the most successful investment among the others agents. The
learning mechanism is a genetic algorithm. After five rounds, agents review their
records and forecast, and they update their forecast methods in order to improve
the forecast ability, i. e., the agents modify the weight of the three components of
the stock return forecast in the order-driven model: the weight of the fundamental
component, the weight of the technical component and the weight of the noisy
component. Hence, differently of the original order-driven model where the value of
the weight is randomly select in the begin of the simulation and does not change over
time; the model with learning, the value of the weight varies along of the simulation
(LeBaron and Yamamoto 2007), which means that agents evolve over time.
Complementary to LeBaron and Yamamoto (2007), LeBaron (2011) argues that
7.2. Future Work
117
the agent-based financial markets present two forms of learning: passive learning
and active learning. On one hand, passive learning refers to the accumulation of
wealth of the successful investment. Successful strategies tends to be a large part
of the market because the strategies that lead to an unsuccessful investment are
abandoned. On the other hand, active learning refers to the adaptations of the
agents on every new information. Instead of abandoned the strategy, such as the
passive learning, the active learner intends to modify the strategies towards to the
strategies that lead to a successful investment.
LeBaron (2011) also argues that in the real markets there are both forms of
learning, passive learning and active learning, in different scales, for three different
reasons. Firstly, passive learning is easy to model because it only requires the
elimination of the bad strategies. Secondly, active learning is not easy to model
because it can involve many degrees of freedom. Finally, active learning can adapt
to the noise in the financial returns.
There is literature of learning in the order-driven model (LeBaron and Yamamoto
2007). However, unlike this thesis, these authors also assume one stock per unit,
i.e., no intelligence in the use of leverage. For this reason, it could be interesting
researches to combine learning, order driven-model and leverage intelligence. The researches could be in three different directions. The first direction is the introduction
of the optimal leverage models in the order-driven model with learning (LeBaron
and Yamamoto 2007). The second direction is the introduction of learning in the
optimal level of leverage models, and the modification of the model in Chapter 6,
in order to empower the agents with the ability to evolve their use of the leverage
over time. Finally, the third direction is the combination of learning in leverage
and learning in the order-driven model. It could be interesting to investigate how
agents evolve on the combination of leverage and trading rules. My insight is that
different levels of leverage could be associated to different strategies. For example,
agents could adapt the level of leverage, and, consequently the size of the order, to
the strategy and evolve his approach on leverage based on the investment outcomes.
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Analysing The Optimal Level of Leverage

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A thesis submitted for the degree of

PhD in Computational Finance

Analysing the optimal level of leverage in stock

Elton Felipe Sbruzzi

Centre for Computational Finance and Economic Agents (CCFEA)

Elton Felipe Sbruzzi

and improve my writing, in a much clear and sophisticated fashion.

Chapter 2: Literature Review . . . . . . . . . . . . . . .

Chapter 4: Optimal Level of Leverage using Numerical Methods

Chapter 3: Proxy Vs Real Geometric

the Optimal Level of

Chapter 6: Agent-Based Modelling of Optimal

Chapter 7: Conclusion and Future Work . . . . . . . . . . . . . . . . . . 107

The plot of the geometric means calculated using numerical methods

The series of prices of NDAQ between 01/11/2002 and 19/10/2007. . 77

The series of cumulative equity return of an investment in NDAQ

Statistical test of the difference between the proxy of the geometric

Statistical Test of the difference between the proxy of the geometric

Statistical analysis of the geometric mean of using the geometric

Statistical analysis of the optimal level of leverage of the use of the

Statistical analysis of the log of the ends of period returns, N = 10

to determine the optimal level of leverage on investments considering the possible

1.2. Research Objectives

normal distribution of the series of historical financial returns.

the agent maintains her level of leverage equal to 10.

Summary of Research Contributions

1.4. Overview and Structure

The second contribution is the introduction of a novel trading strategy which

Overview and Structure

Chapter 2. Literature Review

difference of price along of two period time:

kt2 = lt2 rt2

where k 2 is the risk of equity return.

Chapter 2. Literature Review

2.2. Return Estimation

Chapter 2. Literature Review

represent short-term returns which can be compounded to represent the long-term

where AA is the arithmetic average, rt is the return obtained on time t.

where GM is the geometric mean of returns.

where GM is the approximation of the geometric mean and 2 is the variance.

2.2. Return Estimation

ward to differentiate and obtain a closed solution of the model.

Assuming 1 < rt 1 and using a Taylor expansion, we obtain:

at . Assuming that rt is so small that if i > 2 then E(ri ) = 0:

Note that GM = ex 1. Thus, using Taylor expansion and Eq. (2.6):

Substituting Eq. (2.6) in Eq. (2.7):

Simplifying Eq. (2.8):

Chapter 2. Literature Review

Investors Objective Function

2.3. Investors Objective Function

Chapter 2. Literature Review

of computer technology compared to todays technology. The lack of technology

2.4. Geometric Mean, Leverage and End of Period Return

Geometric Mean, Leverage and End of Period

Single Period Equity Return

In this subsection, I demonstrate that the end of period return is dependent on

Chapter 2. Literature Review

where Lt is the leverage. The value of the portfolio of stocks is:

Kt+1 = Kt (1 + rt+1 lt+1 )

2.4. Geometric Mean, Leverage and End of Period Return

kt+1 (lt+1 ) = rt+1 lt+1

Geometric Mean and End of Period Return

Chapter 2. Literature Review