Reconciling Estimates of the Speed of Adjustment of Leverage Ratios

49 Pages Posted: 26 Jan 2010 Last revised: 22 Oct 2010

Peter Iliev

Pennsylvania State University - Department of Finance

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: October 20, 2010

Abstract

A number of prominent papers in the literature have estimated the average speed of adjustment (SOA) of firms’ leverage ratios with estimators not designed for applications in which the dependent variable is a ratio. These statistics indicate mean reversion, which the papers mistakenly interpreted as deliberate readjustment. We propose a non-parametric way to model leverage ratios under the null hypothesis of random corporate behavior — a placebo process — and embed it with the common alternative of reverting to a target. We show that the empirical estimates previously documented were not only too low, but map into two estimates of the underlying parameter — one with a positive but very slow speed of readjustment, and one with a small negative speed of readjustment (as suggested in Baker and Wurgler (2002) and Dittmar and Thakor (2007)). The best inference to be drawn from the same estimators reported in the literature is the latter, i.e., the true SOA is mildly negative. The average manager does not seem to move back towards a target ratio.

Keywords: Capital Structure, Leverage Ratios, Speed of Adjustment

JEL Classification: G32

Suggested Citation

Iliev, Peter and Welch, Ivo, Reconciling Estimates of the Speed of Adjustment of Leverage Ratios (October 20, 2010). Available at SSRN: https://ssrn.com/abstract=1542691 or http://dx.doi.org/10.2139/ssrn.1542691

Peter Iliev

Pennsylvania State University - Department of Finance ( email )

348 Business Building
University Park, PA 16802
United States

Ivo Welch (Contact Author)

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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