Published online by Cambridge University Press: 12 May 2020
This article investigates how the asset-return variance risk premium changes leverage. I find that the premium reduces leverage by increasing risk-neutral bankruptcy probability and costs in a model where asset returns have stochastic variance with the risk premium. Empirically, the model calibrations verify a significant reduction in optimal leverage, closer to observed leverage than the model without the premium. In model-free regressions, I document that leverage correlates negatively with the variance premium. The highest negative correlation is among investment-grade firms with low asset beta and historical variance but high variance premiums because their assets have high exposure to the market’s variance premium.
I am indebted to Jan Ericsson and Aytek Malkhozov (my co-supervisors), my PhD thesis defense committee, Jarrad Harford (the editor), and JingZhi Huang (the referee). I thank Amir Akbari, Sebastien Betermier, Tolga Cenesizoglu, Georges Dionne, Christian Dorion, Evan Dudley, Redouane Elkamhi, Barry Feldman, Dirk Hackbarth, Nelson Heintz, Ali Jafari, Januj Juneja, Jaemin Kim, Marie Lachance, Hugues Langlois, Edward Lawrence, Stefan Nagel, Chris Parsons, Mehdi Salehizadeh, Sergei Sarkissian, Nabil Tahani, Timothy Trombley, and Nikhil Varaiya and the participants and discussants in the seminars at McGill University and San Diego State University, the 2014 Mathematical Finance Days, the 2015 Financial Management Association Meeting, the 2015 Midwest Finance Association Meeting, and the 2016 Global Finance Conference for their helpful comments. Part of this research was conducted in CyberLab at Indiana University–Purdue University Indianapolis. Financial support was provided by the Institut de Finance Mathèmatique de Montreal (IFM2). All errors are mine. Codes and data with pseudo IDs to replicate this article’s figures and tables are available at. http://www.babakl.com/research.
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