Variance Risk Premia and Capital Structure

66 Pages Posted: 3 Dec 2012 Last revised: 25 Nov 2018

See all articles by Babak Lotfaliei

Babak Lotfaliei

Finance Department, San Diego State University

Date Written: October 1, 2014


This paper shows that the optimal leverage decreases with asset volatility risk in a trade-off framework. Thus, the paper relates the asset volatility risk premium to the underleverage puzzle. In models without volatility risk, the paper empirically documents that underleverage increases with the assets' volatility risk premium. In particular, the underleverage is most important for investment-grade firms with low historical volatility and high volatility risk premium. With volatility risk, two models in standard trade-off settings show that a higher premium implies lower leverage. Empirically, the models' calibration leaves no significant underleverage patterns in the cross-section of the firms. Hence, high asset volatility risk premia contributes to the apparent underleverage in the firms with relatively low historical asset volatility.

Keywords: Capital structure, Volatility risk

JEL Classification: G32, G33, G12

Suggested Citation

Lotfaliei, Babak, Variance Risk Premia and Capital Structure (October 1, 2014). Journal of Financial and Quantitative Analysis (JFQA), Accepted and 2018 Forthcoming, Available at SSRN: or

Babak Lotfaliei (Contact Author)

Finance Department, San Diego State University ( email )

5500 Campanile Drive
San Diego, CA 92182-8236
United States
+16195944790 (Phone)


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