The Risk Anomaly Tradeoff of Leverage

48 Pages Posted: 28 Mar 2016 Last revised: 7 Jun 2023

See all articles by Malcolm P. Baker

Malcolm P. Baker

Harvard Business School; National Bureau of Economic Research (NBER)

Mathias Hoeyer

University of Oxford

Jeffrey Wurgler

NYU Stern School of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: March 2016

Abstract

Higher-beta and higher-volatility equities do not earn commensurately higher returns, a pattern known as the risk anomaly. In this paper, we consider the possibility that the risk anomaly represents mispricing and develop its implications for corporate leverage. The risk anomaly generates a simple tradeoff theory: At zero leverage, the overall cost of capital falls as leverage increases equity risk, but as debt becomes riskier the marginal benefit of increasing equity risk declines. We show that there is an interior optimum and that it is reached at lower leverage for firms with high asset risk. Empirically, the risk anomaly tradeoff theory and the traditional tradeoff theory are both consistent with the finding that firms with low-risk assets choose higher leverage. More uniquely, the risk anomaly theory helps to explain why leverage is inversely related to systematic risk, holding constant total risk; why leverage is inversely related to upside risk, not just downside risk; why numerous firms maintain low or zero leverage despite high marginal tax rates; and, why other firms maintain high leverage despite little tax benefit.

Suggested Citation

Baker, Malcolm P. and Hoeyer, Mathias and Wurgler, Jeffrey A., The Risk Anomaly Tradeoff of Leverage (March 2016). NBER Working Paper No. w22116, Available at SSRN: https://ssrn.com/abstract=2755388

Malcolm P. Baker (Contact Author)

Harvard Business School ( email )

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HOME PAGE: http://www.people.hbs.edu/mbaker

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Mathias Hoeyer

University of Oxford

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Jeffrey A. Wurgler

NYU Stern School of Business ( email )

Stern School of Business
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212-995-4233 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~jwurgler/

National Bureau of Economic Research (NBER)

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United States

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