Leverage- and Cash-Based Tests of Risk and Reward with Improved Identification

Abstract

Leverage offers not only its own directional implications for both risk and reward, but also facilitates superior tests of risk-reward theories: Leverage can change with and without corporate intervention, sometimes even discontinuously. In better-identified contexts, it is more difficult to blame omitted factors, contamination, information, or corporate responses. The evidence suggests that changes in leverage increase volatility but decrease average returns. These effects appear in the large panel of U.S. stock returns, survive progressively better empirical identification, and even hold in equity issuing and dividend payment quasi-experiments.

Keywords: Leverage, Risk, Reward, Quasi Experiments, Behavioral Finance

JEL Classification: G12, G31, G32, G35