Leveraged CAPM

38 Pages Posted: 15 Jan 2010 Last revised: 23 Aug 2010

See all articles by Jörg Seidel

Jörg Seidel

University of Hamburg - Faculty of Economics and Business Administration, Chair of Corporate and Ship Finance

Date Written: May 22, 2010

Abstract

This paper documents that the size effect (Banz, 1981) and the contrarian effect (DeBondt and Thaler, 1985) can be explained by a measurement error in beta. This measurement error results from a change in financial leverage during the beta estimation window. Based on simulations of asset returns, we find that the size of the bias in equity returns is proportional to the change in leverage, as suggested by Modigliani and Miller's (1958) proposition II. We propose a "point-in-time" beta that incorporates the leverage at the end of the beta estimation window rather than the average leverage within this window. Using the "point-in-time" beta to compute expected returns for a broad sample of US stocks, we document that the size effect reduces and the contrarian effect vanishes. In contrast to previous explanations of these CAPM anomalies, our approach does not introduce frictions, additional risk factors, or any other degrees of freedom to the CAPM, and it is consistent with the risk-return considerations in standard capital structure theory.

Keywords: CAPM, beta, leverage, size effect, contrarian effect, anomaly

JEL Classification: C15, C21, G12, G10, G32

Suggested Citation

Seidel, Jörg, Leveraged CAPM (May 22, 2010). Available at SSRN: https://ssrn.com/abstract=1537002 or http://dx.doi.org/10.2139/ssrn.1537002

Jörg Seidel (Contact Author)

University of Hamburg - Faculty of Economics and Business Administration, Chair of Corporate and Ship Finance

Von-Melle-Park 5
Hamburg, 20146
Germany

HOME PAGE: http://www.iff-uhh.de/en/team/usf/joerg-seidel.html

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