Betting on Leverage

51 Pages Posted: 5 Apr 2019

See all articles by Kimberly Cornaggia

Kimberly Cornaggia

Pennsylvania State University - Department of Finance

Timothy T. Simin

Pennsylvania State University

Fatma Sonmez-Leopold

Martin J. Whitman School of Manamegent

Date Written: March 13, 2019

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

Suggested Citation

Cornaggia, Kimberly and Simin, Timothy T. and Sonmez-Leopold, Fatma, Betting on Leverage (March 13, 2019). Available at SSRN: https://ssrn.com/abstract=3352156 or http://dx.doi.org/10.2139/ssrn.3352156

Kimberly Cornaggia (Contact Author)

Pennsylvania State University - Department of Finance ( email )

306 Business Bldg
University Park, PA 16802
United States
814-865-2243 (Phone)
814-865-3362 (Fax)

HOME PAGE: http://directory.smeal.psu.edu/kjr15

Timothy T. Simin

Pennsylvania State University ( email )

University Park, PA 16802
United States
814-865-3457 (Phone)

HOME PAGE: http://timsimin.net

Fatma Sonmez-Leopold

Martin J. Whitman School of Manamegent ( email )

721 University Avenue
Syracuse, NY 13244-2130
United States

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