Leverage, return, volatility and contagion: Evidence from the portfolio framework

When regulating the financial system, the volatility phenomenon seems to emerge, practically, as a phenomenon which is intrinsic to the capital market behaviour. Theoretically, the leverage of the firms appears to be a major determinant of the volatility of prices and returns. At the same time, the leverage has also got a role at both levels: the capital structure of the firm and the investors’ strategy. We examine the return and volatility in relation to leverage by considering different sized portfolios constructed based on the firm’s level of debt and taken from a panel of 320 firms distributed over eight European countries and classified by their level of debt and their size. The optimal portfolio weights are computed for each quarter by maximizing the value of Sharpe ratio. We analyze the return, the volatility and the Value at Risk (VaR) based on different investors’ strategies with a view to taking into account the capital structure and the level of the debt of the firms. Our findings tend to indicate that in the case of two separate equity funds (low debt and high debt), the optimal portfolio is obtained for a weight with high low debt fund. Overall, the leverage seems to have a big role for the portfolio return, volatility and value at risk (VaR). The high leverage is indicative of having a big role in making worse the portfolio return and volatility under shocks. Finally, we explore the value of systematic risk in the case of several portfolio strategies based on high and low debt in regard to the benchmark index (the MSCI Europe index). The presence of these effects is further explored through the response of the model's variables to market-wide return and volatility shocks.