Embedded Leverage

62 Pages Posted: 28 Apr 2020

See all articles by Andrea Frazzini

Andrea Frazzini

AQR Capital Management, LLC

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

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Date Written: April 3, 2020

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

Suggested Citation

Frazzini, Andrea and Pedersen, Lasse Heje, Embedded Leverage (April 3, 2020). Available at SSRN: https://ssrn.com/abstract=3567856 or http://dx.doi.org/10.2139/ssrn.3567856

Andrea Frazzini

AQR Capital Management, LLC ( email )

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HOME PAGE: http://www.econ.yale.edu/~af227/

Lasse Heje Pedersen (Contact Author)

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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