Leverage and the Beta Anomaly
40 Pages Posted: 31 Aug 2016 Last revised: 14 Jan 2019
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Leverage and the Beta Anomaly
The Risk Anomaly Tradeoff of Leverage
Date Written: January 14, 2019
Abstract
The well-known weak empirical relationship between beta risk and the cost of equity--the
beta anomaly--generates a simple tradeoff theory: As firms lever up, the overall cost of
capital falls as leverage increases equity beta, but as debt becomes riskier the marginal
benefit of increasing equity beta declines. As a simple theoretical framework predicts, we
find that leverage is inversely related to asset beta, including upside asset beta, which is
hard to explain by the traditional leverage tradeoff with financial distress that emphasizes
downside risk. The results are robust to a variety of specification choices and control
variables.
Keywords: risk anomaly, capital structure, leverage
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