Leverage- and Cash-Based Tests of Risk and Reward With Improved Identification

Leverage offers not only its own directional implications for both risk and reward, but also facilitate superior tests of risk-reward theories: Leverage can change with and without corporate intervention, and even discontinuously so. The evidence suggests that leverage not only lowers average rates of return (Fama and French (1992)), but also raises volatility. Changes in leverage work even better. These effects appear in the large panel of U.S. stock returns, survive progressively better empirical identification, and even hold in quasi-experimentally identified discontinuity tests using dividend and equity issues. Unlike many other asset-pricing anomalies, it is difficult to see how this could be attributed to omitted factors, contamination, information, or corporate responses. It raises fundamental questions about the perfect-market risk-reward paradigm.