The Pricing of Size, Book to Market and Financial Leverage in Euro Stocks

Abstract:     
Despite the relevance of corporate leverage in a firm’s financial risk, it has not been extensively investigated with reference to asset pricing. In this paper we use a sample of listed equities from nine European Union countries spanning over a period of twenty years (1989-2008). We form size, book to market and leverage portfolios to examine if leverage premium (HLMLL) is systematic and augmenting three factor model by leverage variable would better explain the portfolio returns. Moreover, we investigate if SMB and HML will capture financial distress in presence of a superior measure based on net leverage. Our results suggest that explanatory power of a four factor model is substantially superior to the “vanilla” version of a three factor model. Despite of significant size and book to market coefficients, we could not find evidence that size and book to market factors capture financial distress in presence of a leverage mimicking factor. SMB and HML are priced in stock returns but what risk they reflect in an international context remained a puzzle.

Number of Pages in PDF File: 22

Keywords: Size, Book to Market, Financial Leverage, Euro Stocks

JEL Classification: G10, G12, G15

working papers series