Embedded Leverage

Abstract

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 empirically that options and leveraged ETFs provide significant amounts of embedded leverage, this embedded leverage increases return volatility in proportion to the embedded leverage, and higher embedded leverage is associated with lower risk-adjusted returns. The results are statistically and economically significant, and we provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics.

Keywords: leverage, options, exchange traded funds, ETFs, asset pricing puzzles

JEL Classification: G02, G11, G12, G13, G14, G20