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The Relative Leverage Premium

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  • Filippo Ippolito
  • Roberto Steri
  • Claudio Tebaldi

Abstract

The existing empirical evidence does not yet provide a clear understanding of how leverage and expected equity returns are related. While some studies show a positive relationship between financial leverage and returns, others conclude that returns are either insensitive or decrease with leverage, after controlling for size and book-to-market. We re-examine this evidence by explicitly accounting for the dynamic nature of a firm’s optimal leverage policy in the presence of frictions. Specifically, consistent with recent dynamic models of capital structure, we allow firms to temporarily deviate from their optimal capital structure due to adjustment costs. For each firm we estimate target leverage, and compute relative leverage as the difference between observed and target leverage. We find that relative leverage is positively and significantly related to expected equity returns, and has a dominant effect over size and book-to-market. The relative leverage premium shows a remarkable symmetry for over- and under-leveraged firms. Finally, the relative leverage premium is not captured by Fama and French’s three-factor model, and it appears to be consistent with rational asset pricing. We conjecture that risk-averse investors require a higher expected return for over-leveraged stocks than for under-leveraged ones because the former are counter-cyclical, while the latter are cyclical.

Suggested Citation

  • Filippo Ippolito & Roberto Steri & Claudio Tebaldi, 2011. "The Relative Leverage Premium," Working Papers 398, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  • Handle: RePEc:igi:igierp:398
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    File URL: ftp://ftp.igier.unibocconi.it/wp/2011/398.pdf
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    References listed on IDEAS

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    Cited by:

    1. Emanuela Giacomini & David Ling & Andy Naranjo, 2015. "Leverage and Returns: A Cross-Country Analysis of Public Real Estate Markets," The Journal of Real Estate Finance and Economics, Springer, vol. 51(2), pages 125-159, August.

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