AbstractMany financial instruments are designed with embedded leverage such as options and leveraged exchange traded funds (ETFs). Embedded leverage alleviates investors’ leverage constraints and, therefore, we hypothesize that embedded leverage lowers required returns. Consistent with this hypothesis, we find that asset classes with embedded leverage offer low risk-adjusted returns and, in the cross-section, higher embedded leverage is associated with lower returns. A portfolio which is long low-embedded-leverage securities and short high-embedded-leverage securities earns large abnormal returns, with t-statistics of 8.6 for equity options, 6.3 for index options, and 2.5 for ETFs. We provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18558.
Date of creation: Nov 2012
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- G0 - Financial Economics - - General
- G1 - Financial Economics - - General Financial Markets
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-12-06 (All new papers)
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- George M. Constantinides & Jens Carsten Jackwerth & Alexi Savov, 2012.
"The Puzzle of Index Option Returns,"
Working Paper Series of the Department of Economics, University of Konstanz
2012-35, Department of Economics, University of Konstanz.
- George M. Constantinides & Jens Carsten Jackwerth & Alexi Savov, 2011. "The Puzzle of Index Option Returns," Working Paper Series of the Department of Economics, University of Konstanz 2011-17, Department of Economics, University of Konstanz.
- John Geanakoplos & Lasse Heje Pedersen, 2012. "Monitoring Leverage," NBER Chapters, in: Risk Topography: Systemic Risk and Macro Modeling National Bureau of Economic Research, Inc.
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