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Variance of deviation from optimal leverage

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  • Mustafa O. Caglayan
  • Diogo Duarte
  • Xiaomeng Lu

Abstract

We show that deviations from the firm's target leverage are priced in the cross‐section of stock returns and that the relation between these quantities is nonlinear. The concave nonlinear relation between deviation from the target leverage and next‐period return is strong during economic expansions and vanishes during recessions. Our portfolio analysis provides support for the concave relation between deviation from the target leverage and next‐period returns as well. We develop a factor named variance of deviation from optimal leverage (VDOL) and show that it is an important risk factor that has been omitted in the literature.

Suggested Citation

  • Mustafa O. Caglayan & Diogo Duarte & Xiaomeng Lu, 2025. "Variance of deviation from optimal leverage," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 48(3), pages 1408-1442, September.
    • Handle: RePEc:bla:jfnres:v:48:y:2025:i:3:p:1408-1442
    DOI: 10.1111/jfir.12438
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