Capital Structure Convergence: Is it Real or Mechanical?

Abstract:     
Lemmon et al. (2008) show two features of the data on capital structure: convergence and persistence. I replicate their results and then explore the source of the convergence feature. I show that capital structure convergence is likely to be mechanical rather than real. It sources from a statistical fallacy called the “regression fallacy”. The stationarity of the leverage ratio series and the misclassification problem in portfolio construction give rise to the apparent convergence. Last, I test an implication of the misclassification argument and propose a method that is able to mitigate the mechanical convergence.

Number of Pages in PDF File: 28

Keywords: Capital Structure, The Regression Fallacy, Mechanical Convergence

JEL Classification: G32

working papers series