In Search of a Leverage Factor in Stock Returns: An Empirical Evaluation of Asset Pricing Models on Swedish Data
Abstract: Theoretical finance regards leverage as one of the sources of stock return risk, and thus claims that the more levered a firm is, the higher the risk for equity holders and the higher the required rate of return. As asset pricing has matured into an important area of finance, new factors have been incorporated into the CAPM, following observed anomalies in stock returns. Despite its centrality within finance, the relationship between leverage and returns has not been extensively researched, and the empirical findings on this subject have been mixed and sometimes contradictive. This thesis investigates if leverage can help to explain stock returns based on Swedish data during the period 1990 to 2009 by testing if leverage can be used as an additional asset pricing factor, and attempting to determine its potential effect on returns. In conjunction with this, the performance of three acknowledged asset pricing models – the CAPM, the Fama-French (1992) three-factor model, and the Carhart (1997) four-factor model – are evaluated. The time series regression results we obtain do not support the hypothesis that a leverage factor can help reduce mispricing of these asset pricing models. From our cross-section regression results we cannot make a statement about the effect of leverage on stock returns. Furthermore, none of the acknowledged asset pricing models perform particularly well on our data. We end our thesis with a discussion on why we obtain these results and how certain adjustments might yield different conclusions.
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