Leverage and Volatility

Abstract: This paper attempts to contribute to existing knowledge through an explicit threefold purpose. Initially, the importance of leverage in explaining equity return volatility is determined through two fixed effects panel data estimations. The panel dataset runs from 1990-2009 and includes 20 years worth of observations for the 45 firms on the Stockholm stock exchange for which data is available. The second purpose is to evaluate the main explanations of asymmetric volatility. This is done for equity return volatility in its totality and for its component parts. The panel dataset is expanded through the addition of the three variables that arise from decomposing volatility into its three constituent parts (firm, industry and market specific volatility) and an approximated measure of risk premium. This leads into the implementation of a VAR-approach in a panel data setting. The last segment sees the construction of five portfolios that are based on the return series of all 45 firms sorted from low to high leverage. Each portfolio return series corresponds to the 9 return-series associated with each leverage quintile for each year, i.e., the portfolio composition changes year-to-year in order to consistently represent the return series of each leverage quintile. This is the operationalization of the third and final purpose which is to determine if the persistence in volatility and degree of volatility asymmetry is higher for higher leverage quintile portfolios. The main findings are that leverage is an important determinant of equity return volatility. However, the evidence is mixed for the idea that leverage influences the persistence of volatility and aggravates asymmetries. Further, special dynamics are at work during periods of financial crisis since certain relations are reversed and/or intensified during these periods. In complement to the purposes expressly pursued, central relations and processes not discussed in the literature are uncovered and recommended for future research.