The Relative Leverage Premium

Posted: 16 Feb 2011 Last revised: 11 Oct 2017

See all articles by Filippo Ippolito

Filippo Ippolito

Universitat Pompeu Fabra - Faculty of Economic and Business Sciences; Barcelona Graduate School of Economics; Centre for Economic Policy Research (CEPR)

Roberto Steri

University of Luxembourg

Claudio Tebaldi

Bocconi University - CAREFIN - Centre for Applied Research in Finance; Bocconi University - Department of Finance; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research

Date Written: September 8, 2011

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.​

Keywords: Leverage, Cross Section of Returns, Target Leverage, Dynamic Capital Structure, Financial Frictions

JEL Classification: G12, G32

Suggested Citation

Ippolito, Filippo and Ippolito, Filippo and Steri, Roberto and Tebaldi, Claudio, The Relative Leverage Premium (September 8, 2011). AFA 2012 Chicago Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1762116 or http://dx.doi.org/10.2139/ssrn.1762116

Filippo Ippolito

Universitat Pompeu Fabra - Faculty of Economic and Business Sciences ( email )

Ramon Trias Fargas 25-27
Barcelona, 08005
Spain
(+34) 93 542 2578 (Phone)
(+34) 93 542 1746 (Fax)

Barcelona Graduate School of Economics ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Roberto Steri (Contact Author)

University of Luxembourg ( email )

Kirchberg, 6, rue Richard Coudenhove-Kalergi
Luxembourg
Luxembourg

HOME PAGE: http://https://sites.google.com/site/robertosteripersonalpage/

Claudio Tebaldi

Bocconi University - CAREFIN - Centre for Applied Research in Finance ( email )

Via Roentgen 1
Milan, 20136
Italy

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research ( email )

Via Roentgen 1
Milan, 20136
Italy

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