Does Financial Leverage Amplify Equity Risk? Theory and Evidence

Abstract

Background: This study aims to examine the fundamental driving forces of the high market-level stock return volatility in a recession. Methods: A production-based asset pricing model is used to show the important roles of both financial and operating leverage and their simultaneous amplification effects on volatility. Results: The quantitative results show that both financial and operating leverage significantly explain the stock return volatility, and that this explanatory power is highest during a recession. Conclusion: In particular, operating leverage is the crucial factor that drives the high volatility during a recession, predicting a higher stock return over time. This relation also implies a source of value premium at the firm level.