Endogenous Leverage and Expected Stock Returns

24 Pages Posted: 5 Aug 2010 Last revised: 6 Dec 2010

Tatiana Chebonenko

University of Illinois at Urbana-Champaign

Xiangyie Xie Spencer

University of Illinois at Urbana-Champaign

Igor Cunha

University of Kentucky

Fabricio D'Almeida

University of Illinois at Urbana-Champaign - Department of Finance; University of Illinois at Urbana-Champaign

Timothy C. Johnson

University of Illinois at Urbana-Champaign

Date Written: November 30, 2010

Abstract

In a recent paper, George and Hwang (2009) assert that endogenous debt choice in a cross-section of diverse firms can imply a negative relation between leverage or distress risk and expected stock returns.

This note clarifies conditions, in the context of their model, under which this is so. We correct the contention that variation in bankruptcy costs is sufficient. Variation in firm risk parameters can lead to the desired relation, but may not when also controlling for variation in book-to-market ratios. A simple parameterization of cross-sectional heterogeneity in risk and profitability implies a negative association of expected return with leverage and distress risk and a positive association with book-to-market.

Keywords: expected stock returns, optimal capital structure

JEL Classification: G12

Suggested Citation

Chebonenko, Tatiana and Spencer, Xiangyie Xie and Cunha, Igor and D'Almeida, Fabricio and Johnson, Timothy C., Endogenous Leverage and Expected Stock Returns (November 30, 2010). Available at SSRN: https://ssrn.com/abstract=1652745 or http://dx.doi.org/10.2139/ssrn.1652745

Tatiana Chebonenko

University of Illinois at Urbana-Champaign ( email )

Urbana, IL 61820
United States

Xiangyie Xie Spencer

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

Igor Cunha

University of Kentucky ( email )

Gatton College of Business and Economics
550 S. Limestone
Lexington, KY 40526
United States
859-257-5703 (Phone)

Fabricio D'Almeida

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

Timothy C. Johnson (Contact Author)

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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