Does reference point matter in the leverage–return relationship? Evidence from the US stock market

The leverage–return relationship is supported by inconclusive empirical evidence in terms of its sign and significance. In this study, we argue that such a puzzling relationship can be understood by extending the traditional theoretical framework in a way that captures the reference dependence characteristics of prospect theory. We postulate that a firm’s leverage position relative to its reference point (i.e. target leverage) combined with market conditions places firms in either a gain or a loss domain, thereby resulting in different leverage–return relationships. Leverage and expected equity returns generally exhibit positive and negative relationships in gain and loss domains, respectively. Three hypotheses are derived and tested using 1998–2013 empirical data from the US stock market. This article contributes to the existing literature by confirming the applicability of prospect theory in explaining expected returns in the stock market.