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)
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
Date posted: November 22, 2012