An additional analysis of estimation techniques for the degree of financial leverage

This study compares three different empirical proxies for the financial leverage component of a systematic risk‐composition model employed in prior financial research. We consider one static accounting measure and two elasticity‐based measures. We find that the traditional static accounting measure of financial leverage provides statistically different estimates of financial leverage when compared to estimates from elasticity‐based measures of the degree of financial leverage. The findings are important because the elasticity‐based models for the degree of financial leverage have clear theoretical links to market‐based models of systematic risk, while the static accounting measure of financial leverage does not. Practitioners and researchers should carefully consider why they are estimating financial leverage and choose the appropriate method for doing so given the goals and potential consequences for biased estimation.     

The relationship between operating leverage and financial leverage

We model the relationship between operating and financial leverage. When operating leverage is exogenously specified, financial leverage is a monotonically decreasing function of operating leverage. When financial leverage is exogenously specified, operating leverage is initially increasing and subsequently decreasing in financial leverage. Finally, when both operating and financial leverage are chosen by the firm, they can be positively related, negatively related or unrelated, depending on which underlying parameter is driving the changes. Thus, operating leverage and financial leverage do not always behave as substitutes, as argued in the traditional literature. The relationship is complex, possibly non-monotonic and dependent on the circumstances; empirical tests need to take this reality into account.     

An Empirical Comparison of Alternative Methods for the Estimation of the Degree of Operating Leverage

Much diversity exists in the approaches used to estimate the degree of operating leverage in empirical financial research. This study analyzes and compares two techniques for the estimation of the degree of operating leverage coefficients for a sample of 245 firms in seven different industries over two alternative estimation periods. The results indicate that the O'Brien and Vanderheiden estimation technique differs significantly from the Mandelker and Rhee estimation technique. Furthermore, the O'Brien and Vanderheiden estimates appear to be more consistent with the classical ex ante model of degree of operating leverage coefficients. These results may facilitate future research on the estimation of the degree of operating leverage and on the relationship between operating leverage and systematic risk.     

Asset liquidity,business risk,and beta

Extant literature posits that because of leverage, equity beta estimates from a single factor capital asset pricing model based on an equity-only market index are biased. We show analytically that this leverage bias is intimately related to the firm's asset structure per se, the firm's asset liquidity (i.e., cash holdings) and business risk. This is mainly because riskless cash holdings and risky real assets jointly determine the relevant risk for asset pricing. We empirically confirm that asset liquidity and business risk can marginally explain the leverage bias in the cross-section of stocks returns.     

Local social environment and the speed of leverage adjustment

This study examines the impact of social capital on firms’ leverage adjustment speed. Using a comprehensive dataset of 83,374 firm-year observations for 744 US counties for 1990–2016, we find that both underleveraged and overleveraged firms located in US counties with higher levels of social capital incur slower leverage adjustment towards their optimal target capital structure. This finding is robust to alternative measures of leverage and social capital, different model specifications, controlling for county- and firm-level characteristics, and endogeneity. We further identify two mechanisms through which social capital affects leverage adjustments: monitoring (channel for underleveraged firms) and disciplinary (channel for overleveraged firms) mechanisms.     

The role of on- and off-balance-sheet leverage of banks in the late 2000s crisis

Extensive regulatory changes and technological advances have transformed banking systems to a great extent. Banks have reacted to the challenges posed by the new operating environment by creating new products and expanding their activities to some uncharted business areas. In this paper, we study how modern banking which gave birth to the off-balance-sheet leverage activities affected the risk profile of U.S. banks as well as the level of systemic risk before and after the onset of the late 2000s financial crisis. Towards this, we separate on- from off-balance-sheet leverage and capture the latter with different, yet complementary, measures which do not exist in the current literature. Special attention is paid on the deleveraging process that occurred in the banking market after the crisis erupted, which is an additional innovative feature of this study. Our findings reveal that leverage, both explicit and hidden off-the-balance-sheet, increases the individual risk of banking firms making them vulnerable to financial shocks. Reverse leverage, on the other hand, is beneficial for individual banks’ health, but is found to be harmful for financial stability. We also demonstrate that the banks which concentrate on traditional lines of business typically carry less risk compared to those involved with modern financial instruments.     

Systematic risk,the tradeoff of leverage and IPO first-day returns

In this paper, we investigate IPO first-day returns in French market. Our focus is to assess the relationship between equity risk, corporate leverage and IPO initial returns. Based on data of 254 French IPOs, traded on Euronext/Alternext markets over the period 2006 and 2016, we find that estimated beta and idiosyncratic volatility are strongly and negatively related to book and market net gearing ratios. We also find that the interaction terms between equity risk measures and corporate leverage ratios are inversely related to IPO first-day returns. In addition, we highlight that industry and macroeconomic environment variables are significant predictors of equity initial returns. Robustness check of our findings indicates less relevant results for corporate leverage when it is estimated as independent variable.

     

Cross-sectional analysis of Swedish stock returns with time-varying beta: the Swedish stock market 1983–96

This paper analyses the ability of beta and other factors, like firm size and book-to-market, to explain cross‐sectional variation in average stock returns on the Swedish stock market for the period 1983–96. We use a bivariate GARCH(1,1) process to estimate time-varying betas for asset returns. The estimated variances of these betas, derived from a Taylor series approximation, are used for correcting errors in variables. An extreme bound analysis is utilized for testing the sensitivity of the estimated coefficients to changes in the set of included explanatory variables.
Our results show that the estimated conditional beta is a more accurate measure of the true market beta than the beta estimated by OLS. The coefficient for beta is not significantly different from zero, while the variables book-to-market and leverage have significant coefficients, and the latter coefficients are also robust to model specification. Excluding the down turn 1990–92 from the sample shows that the significance of the risk premium for leverage might be considered as an industry effect during this extreme period. Finally, we find a close dependence between the risk premium for beta and that for size and book-to-market. The omission of each of these variables may cause statistical bias in the estimated coefficient for beta.     

Properties of time-series estimates of degree of leverage measures

Empirical studies suggest that time-series regression estimates of the degrees of operating and financial leverage have a tendency to produce measures less than one. According to ex ante theory, these measures should be greater than one for firms operating above the breakeven point. There have also been suggestions that the biases in these estimates may be attributable to an underlying increase in unit sales. This work presents evidence that these counter-intuitive measures are produced by changes in the firm's operating parameters (unit price, variable cost, fixed cost and interest payments). It further suggests that attempts to control for the underlying change in unit sales substantially increase the volatility of predicted estimates.     

Country world betas: The link between the stock market beta and macroeconomic beta

We assess the connection between stock market linkages and macroeconomic linkages by using a world index model. Specifically, we test the association between the stock market beta (the sensitivity of country stock market index to world index) and macroeconomic betas (the sensitivity of national output and inflation to world output and inflation). Output betas account for about 20–26% of the cross-section of stock market betas. Controlling for previously-documented factors affecting stock market comovements: world output volatility is somewhat significant, while inflation betas, trade openness and world stock market volatility are insignificant in accounting for variation in stock market betas.     

Determinants of market beta: the impacts of firm-specific accounting figures and market conditions

This article examines and extends research on the relation between the capital asset pricing model market beta, accounting risk measures and macroeconomic risk factors. We employ a beta decomposition approach that nests competing models with different business risk proxies and allows to frame cross-model comparison. Because model tests require estimated independent variables resulting in measurement error, we empirically estimate three comparable model specifications with instrumental variable estimators and for the first time provide thorough instrument diagnostics in this setting. Correcting for the heretofore neglected weak instruments problem we find that growth risk (i.e., the risk of firm sales variations that are inconsistent with the market wide trends), is the business risk that explains cross-sectional variations in market beta best.     

What explains the value premium? The case of adjustment costs,operating leverage and financial leverage

This paper empirically examines and compares the different theoretical predictions on how adjustment costs, operating and financial leverage influence the value premium. Consistent with Ozdagli (2012), financial leverage plays a dominant role, supported by adjustment costs (which represent the degree of investment irreversibility). Specifically, the observed value premium is driven by the financial leverage differences between value and growth firms, partially neutralized by investment irreversibility. The relation between the value premium and investment irreversibility is contrary to the intuition in Zhang (2005) and Cooper (2006). Operating leverage does not significantly influence the value premium.     

Informational leverage: the problem of noise traders

The literature suggests that security design can be used to manipulate the information content of securities prices [what is referred to as the “informational leverage effect” in Boot and Thakor (J Finance 48, 1349–1378, 1993)]. The informational leverage effect arises in this literature in a market microstructure environment in which noise trade is exogenous, which is a fairly standard assumption dating back to the framework developed in Grossman and Stiglitz (Am Econ Rev 70, 393–408, 1980). This assumption is relaxed in our paper, and we show that the informational effects described in the related literature become less clear cut when noise trading activity is endogenous. We find that the intensity and direction of these effects depends crucially on the parameters describing the modeling environment. The elegant point of the informational leverage literature is that these effects arise largely independently of such parameters, but with endogenous noise trading that is no longer true. This literature may, therefore, lead to too strong conclusions being drawn about the relationship between information revelation and security design. We are very grateful for the helpful comments made by an anonymous referee.     

Behavioral consistency in corporate finance: CEO personal and corporate leverage

We find that firms behave consistently with how their CEOs behave personally in the context of leverage choices. Analyzing data on CEOs' leverage in their most recent primary home purchases, we find a positive, economically relevant, robust relation between corporate and personal leverage in the cross-section and when examining CEO turnovers. The results are consistent with an endogenous matching of CEOs to firms based on preferences, as well as with CEOs imprinting their personal preferences on the firms they manage, particularly when governance is weaker. Besides enhancing our understanding of the determinants of corporate capital structures, the broader contribution of the paper is to show that CEOs' personal behavior can, in part, explain corporate financial behavior of the firms they manage.     

Historical market-to-book in a partial adjustment model of leverage

Historical market-to-book has been shown to explain current leverage. Prior studies attribute the evidence to market timing. This study shows that with the presence of time-varying targets and adjustment costs, historical market-to-book has a significant impact on leverage even when firms do not time the market. The historical values of alternative market timing proxies, such as insider sales and the market sentiment index, are shown to have no effects on leverage while the historical values of alternative growth-option proxies do have effects. Overall, the evidence is largely consistent with a partial adjustment model of leverage.     

A comparative analysis of proxies for an optimal leverage ratio

Previous studies that test the tradeoff theory commonly use one of the following debt ratio measures to proxy for a firm's hypothesized optimal ratio: firm's time-series mean leverage, moving average leverage based on a firm's historical debt ratios, industry median leverage, and predicted leverage ratio based on cross-sectional regressions. We find that these alternative proxies yield results that are significantly different from each other. Further, regression results of models that use the optimum target leverage and the conclusions drawn from the findings are sensitive to the model's proxy. Of the proxies that are commonly used in the literature, the moving average debt measure exhibits characteristics that are most consistent with the theoretical optimal leverage ratio.     

The effect of financial leverage on real and accrual-based earnings management

Past research has documented a substitution effect between real earnings management (RM) and accrual-based earnings management (AM), depending on relative costs. This study contributes to this research by examining whether levels of (and changes in) financial leverage have an impact on this empirically documented trade-off. We hypothesise that in the presence of high leverage, firms that engage in earnings manipulation tactics will exhibit a preference for RM due to a lower possibility – and subsequent costs – of getting caught. We show that leverage levels and increases positively and significantly affect upward RM, with no significant effect on income-increasing AM, while our findings point towards a complementarity effect between unexpected levels of RM and AM for firms with very high leverage levels and changes. This is interpreted as an indication that high leverage could attract heavy outsider scrutiny, making it necessary for firms to use both forms of earnings management in order to achieve earnings targets. Furthermore, we document that equity investors exhibit a significantly stronger penalising reaction to AM vs. RM, indicating that leverage-induced RM is not as easily detectable by market participants as debt-induced AM, despite the fact that the former could imply deviation from optimal business practices.     

The funding of subsidiaries equity,double leverage and the risk of bank holding companies

Banking groups exploit double leverage when ‘debt is issued by the parent company and the proceeds are invested in subsidiaries as equity’. Financial authorities have frequently raised concerns about the issue of double leverage because this type of intra‐firm financing appears to allow for both the arbitrage of capital and the assumption of risk. This article focuses on the relationship between double leverage and risk‐taking within banking groups. First, we discuss this relationship based on an examination of balance sheet figures. Second, we analyze a large sample of United States Bank Holding Companies (BHCs) from 1990–2014. The results show that BHCs are more prone to risk when they increase their double leverage, namely, when the stake of the parent within subsidiaries is larger than the stand‐alone capital of the parent. This paper's primary implication for policymakers is that the regulators of complex financial entities should more efficiently address the issue of double leverage, thereby limiting the potential negative consequences that arise from corporate instability.     

The reduced-rank beta in linear stochastic discount factor models

In a linear stochastic discount factor model, failure of the full-rank conditions affects the standard statistical inference of coefficients. We propose a novel risk measurement, the reduced-rank beta, which is the risk sensitivity to the effective part of factors for the full-rank covariance matrix. Our reduced-rank beta is a generalisation of the standard beta when the full-rank condition is not satisfied. By considering the Fama–French five-factor (FF5) model for the US equity market, the failure of the full-rank condition is found to affect beta estimates. We demonstrate the reduced-rank beta has important empirical implications for model reductions and anomaly explanations.     

THE OPERATING BETA OF A U.S. MULTI-ACTIVITY FIRM: AN EMPIRICAL INVESTIGATION

Various researchers have decomposed the firm's beta (or systematic risk) into components that are reflective of the firm's corporate characteristics, for example, leverage position, product mix, etc. In this paper, the theoretical beta decompositions of Hamada (1969 and 1972) and Rubinstein (1973) are sub- jected to empirical examination for a sample of diversified (or multi-activity) firms. The results of the analysis evidence highly significant empirical support for the Hamada- Rubinstein model and for the viability of operationalizing that model with available accounting and market data.