Leverage and the Cross‐Section of Equity Returns

Leverage and the Cross‐Section of Equity Returns

  • HITESH DOSHI
  • KRIS JACOBS
  • PRAVEEN KUMAR
  • RAMON RABINOVITCH

Article first published online: 11th February 2019 DOI: 10.1111/jofi.12758

Abstract


Building on theoretical asset pricing literature, we examine the role of market risk and the size, book‐to‐market (BTM), and volatility anomalies in the cross‐section of unlevered equity returns. Compared with levered (stock) returns, unlevered market beta plays a more important role in explaining the cross‐section of unlevered equity returns, even after controlling for size and BTM. The size effect is weakened, while the value premium and the volatility puzzle virtually disappear for unlevered returns. We show that leverage induces heteroskedasticity in returns. Unlevering returns removes this pattern, which is otherwise difficult to address by controlling for leverage in regressions.

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