Leveraged CAPM
38 Pages Posted: 15 Jan 2010 Last revised: 23 Aug 2010
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: Suggested Citation