Betting on Leverage

Abstract

We combine classic corporate finance theory of capital structure with an asset pricing theory of leverage-constrained investors to explain why CAPM beta is negatively related to abnormal stock returns. Current theory explaining this anomaly suggests that leverage constrained investors tilt portfolios towards high-beta stocks. With a stylized analytical model and simulation, we show leverage-constrained investors rationally tilt investment, not towards high-beta firms generally but specifically towards those with high financial leverage. The advantage to adding levered firms, rather than an unlevered firms with comparably high betas, comes through lower covariance of the levered assets with the market portfolio. Informed by a continuous-time capital structure model, we estimate the varying impact of firm-level financial leverage on market risk measures and document two novel contributions. First, we find no remaining evidence of the anomalous low returns to high beta stocks. Second, we formally test an adjusted model of leverage-constrained investors and conclude that such constraints have practical implications for investors and for asset pricing models.

Keywords: beta, betting against beta, CAPM, asset beta, unlevered beta, stock returns

JEL Classification: G01, G11, G12, G14, G15