Leverage and the Cross-Section of Equity Returns

Building on the 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. Consistent with the theory, the unlevered market beta helps explain the cross-section of unlevered equity returns even when we control for the size and BTM factors. The value premium and the volatility puzzle disappear for unlevered returns, but the size discount remains consistent with Berk (1995). We revisit the relationship between leverage and levered stock returns, which is highly nonlinear. Accounting for heteroskedasticity in stock returns due to leverage con…rms the empirical …ndings from unlevered returns. Keywords: Leverage; unlevered equity returns; asset beta; value premium; size discount; volatility puzzle; heteroskedasticity. JEL classi…cation codes: G12 We would like to thank Jack Bao, Tony Berrada, Jaewon Choi, Peter Christo¤ersen, Jan Ericsson, Steve Figlewski, Michael Gordy, Rawley Heimer, Adam Kolasinski, David Lesmond, Yan Liu, Rajnish Mehra, Lubos Pastor, Rauli Susmel, Sheri Tice, Jules van Binsbergen, Stijn Van Nieuwerburgh, Anand Vijh, Ulf Von Lilienfeld, Robert Whitelaw, Tong Yao, seminar participants at Tulane University, New York University, Texas A&M, the University of Iowa, West Virginia University, the University of Luxembourg, the University of Geneva, the Federal Reserve Board, the NFA, FMA, and SoFiE meetings and the SFS Cavalcade (Toronto), and especially Yakov Amihud and Rob Engle for helpful comments. Please send correspondence to Kris Jacobs, C.T. Bauer College of Business, 334 Melcher Hall, University of Houston, Houston, TX 77204-6021, USA; Telephone: (713) 743-2826; E-mail: [email protected].