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Levered Returns

Author

Listed:
  • Lukas Schmid

    (University of Lausanne)

  • Joao Gomes

    (University of Pennsylvania)

Abstract

In this paper we investigate the theoretical relation between financial leverage and stock returns in a dynamic world where both the corporate investment and financing decisions are endogenous. We find that the link between leverage and stock returns is more complex than the static textbook examples suggest and will be determined by the interplay of the firm’s investment opportunities and default risk which vary systematically with macroeconomic conditions. In the presence of financial market imperfections leverage and investment are generally correlated so that highly levered firms are also mature firms with relatively more (safe) book assets and fewer (risky) growth opportunities. We first formalize this in a simple continuous-time model and then show that a quantitative version of our model can replicate both the evidence in Bhandari (1988) and Fama and French (1992) about the effects of leverage on returns and the results in Welch (2004) about the impact of returns on leverage ratios.

Suggested Citation

  • Lukas Schmid & Joao Gomes, 2007. "Levered Returns," 2007 Meeting Papers 1007, Society for Economic Dynamics.
  • Handle: RePEc:red:sed007:1007
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    References listed on IDEAS

    as
    1. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    2. John M. Griffin & Michael L. Lemmon, 2002. "Book-to-Market Equity, Distress Risk, and Stock Returns," Journal of Finance, American Finance Association, vol. 57(5), pages 2317-2336, October.
    3. John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2008. "In Search of Distress Risk," Journal of Finance, American Finance Association, vol. 63(6), pages 2899-2939, December.
    4. Christopher A. Hennessy & Toni M. Whited, 2007. "How Costly Is External Financing? Evidence from a Structural Estimation," Journal of Finance, American Finance Association, vol. 62(4), pages 1705-1745, August.
    5. Eugene F. Fama, 2002. "Testing Trade-Off and Pecking Order Predictions About Dividends and Debt," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 1-33, March.
    6. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-1252, September.
    7. Ron Giammarino & Murray Carlson & Adlai Fisher, 2004. "Corporate Investment and Asset Price Dynamics: Implications for Post-SEO Performance," 2004 Meeting Papers 812, Society for Economic Dynamics.
    8. Bhandari, Laxmi Chand, 1988. " Debt/Equity Ratio and Expected Common Stock Returns: Empirical Evidence," Journal of Finance, American Finance Association, vol. 43(2), pages 507-528, June.
    9. Murray Carlson & Adlai Fisher & Ron Giammarino, 2004. "Corporate Investment and Asset Price Dynamics: Implications for the Cross-section of Returns," Journal of Finance, American Finance Association, vol. 59(6), pages 2577-2603, December.
    10. Ivo Welch, 2004. "Capital Structure and Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 106-131, February.
    11. Joao Gomes & Leonid Kogan & Lu Zhang, 2003. "Equilibrium Cross Section of Returns," Journal of Political Economy, University of Chicago Press, vol. 111(4), pages 693-732, August.
    12. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, vol. 59(2), pages 831-868, April.
    13. Ilia D. Dichev, 1998. "Is the Risk of Bankruptcy a Systematic Risk?," Journal of Finance, American Finance Association, vol. 53(3), pages 1131-1147, June.
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