Abstract - The Relative Leverage Premium

The existing empirical evidence does not yet provide a clear understanding of how leverage and expected equity returns are related. While in some studies the relationship between financial leverage and returns is positive, in others returns are either insensitive or decrease with leverage. 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, 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.

Claudio Tebaldi
University Bocconi, Milano
07. Feb 2012

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