The Risk Anomaly Tradeoff of Leverage / Malcolm Baker, Mathias F. Hoeyer, Jeffrey Wurgler.

Format:

Book

Author/Creator:

Baker, Malcolm.

Contributor:

National Bureau of Economic Research.

Hoeyer, Mathias F.

Wurgler, Jeffrey.

Series:

Working Paper Series (National Bureau of Economic Research) no. w22116.

NBER working paper series no. w22116

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2016.

Summary:

Higher-beta and higher-volatility equities do not earn commensurately higher returns, a pattern known as the risk anomaly. In this paper, we consider the possibility that the risk anomaly represents mispricing and develop its implications for corporate leverage. The risk anomaly generates a simple tradeoff theory: At zero leverage, the overall cost of capital falls as leverage increases equity risk, but as debt becomes riskier the marginal benefit of increasing equity risk declines. We show that there is an interior optimum and that it is reached at lower leverage for firms with high asset risk. Empirically, the risk anomaly tradeoff theory and the traditional tradeoff theory are both consistent with the finding that firms with low-risk assets choose higher leverage. More uniquely, the risk anomaly theory helps to explain why leverage is inversely related to systematic risk, holding constant total risk; why leverage is inversely related to upside risk, not just downside risk; why numerous firms maintain low or zero leverage despite high marginal tax rates; and, why other firms maintain high leverage despite little tax benefit.

Notes:

Print version record

March 2016.