Citations (6)



Embedded Leverage

Andrea Frazzini

AQR Capital Management, LLC

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

November 2012

NBER Working Paper No. w18558

Many financial instruments are designed with embedded leverage such as options and leveraged exchange traded funds (ETFs). Embedded leverage alleviates investors' leverage constraints and, therefore, we hypothesize that embedded leverage lowers required returns. Consistent with this hypothesis, we find that asset classes with embedded leverage offer low risk-adjusted returns and, in the cross-section, higher embedded leverage is associated with lower returns. A portfolio which is long low-embedded-leverage securities and short high-embedded-leverage securities earns large abnormal returns, with t-statistics of 8.6 for equity options, 6.3 for index options, and 2.5 for ETFs. We provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics.

Number of Pages in PDF File: 60

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Date posted: November 22, 2012  

Suggested Citation

Frazzini, Andrea and Pedersen, Lasse Heje, Embedded Leverage (November 2012). NBER Working Paper No. w18558. Available at SSRN: https://ssrn.com/abstract=2179396

Contact Information

Andrea Frazzini (Contact Author)
AQR Capital Management, LLC ( email )
Two Greenwich Plaza, 3rd Floor
Greenwich, CT 06830
United States
203-742-3894 (Phone)
203-742-3394 (Fax)
HOME PAGE: http://www.econ.yale.edu/~af227/

Lasse Heje Pedersen
AQR Capital Management, LLC ( email )
Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )
Solbjerg Plads 3
Frederiksberg, DK-2000
New York University (NYU) ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
Centre for Economic Policy Research (CEPR) ( email )
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
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