Is the 'Leverage Effect' a Leverage Effect?

40 Pages Posted: 12 Jan 2001

See all articles by Stephen Figlewski

Stephen Figlewski

New York University - Stern School of Business

Xiaozu Wang

City University of Hong Kong (CityU) - Department of Economics & Finance

Date Written: November 2000

Abstract

The "leverage effect" refers to the well-established relationship between stock returns and both implied and realized volatility: volatility increases when the stock price falls. A standard explanation ties the phenomenon to the effect a change in market valuation of a firm's equity has on the degree of leverage in its capital structure, with an increase in leverage producing an increase in stock volatility. We use both returns and directly measured leverage to examine this hypothetical explanation for the "leverage effect" as it applies to the individual stocks in the S&P100 (OEX) index, and to the index itself. We find a strong "leverage effect" associated with falling stock prices, but also numerous anomalies that call into question leverage changes as the explanation. These include the facts that the effect is much weaker or nonexistent when positive stock returns reduce leverage; it is too small with measured leverage for individual firms, but much too large for OEX implied volatilities; the volatility change associated with a given change in leverage seems to die out over a few months; and there is no apparent effect on volatility when leverage changes because of a change in outstanding debt or shares, only when stock prices change. In short, our evidence suggests that the "leverage effect" is really a "down market effect" that may have little direct connection to firm leverage.

JEL Classification: g13, g12, g32

Suggested Citation

Figlewski, Stephen and Wang, Xiaozu, Is the 'Leverage Effect' a Leverage Effect? (November 2000). Available at SSRN: https://ssrn.com/abstract=256109 or http://dx.doi.org/10.2139/ssrn.256109

Stephen Figlewski (Contact Author)

New York University - Stern School of Business ( email )

NY
United States
9732206916 (Phone)
07043 (Fax)

Xiaozu Wang

City University of Hong Kong (CityU) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong
852 2788 7407 (Phone)

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