The Relation Between Leverage, Beta, and Stock Returns An Empirical Study
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- Master Thesis 
This thesis aims to shed some light on, and hopefully add to the economic puzzle that is the relationship between leverage, return, and systematic risk. The theory surrounding this particular topic, suggests that there should be a positive relationship between them. The research, however, gives contradictory results, leading to it being quite controversial. When applying a cross-sectional approach to our CRSP and CRSP/Compustat merged dataset, we find that leverage partly hold information on changes in equity returns, both positively and negatively related from Fama-MacBeth (1973) regression analysis, which supports both Hamada (1972) as well as Fama and French (1992). However, our empirical results suggest the leverage effect to have the strongest explanatory power when adjusting for beta and size effects. Thus, our thesis supports Modigliani and Miller (1958) and Hamada (1972), proving increased market leverage to hold information on increased returns. Contradictive to those results, we provide in accordance with Fama and French (1992), evidence of book leverage being negatively related to stock returns. Furthermore, our results provide strong evidence supporting the CAPM provided by Sharpe (1964), with a short-horizon beta to hold strong explanatory power in increased equity returns. However, when adjusting for a beta estimated over a longer period, these effects tend to disappear. Also, our results provide evidence of leverage not being positively, nor siginificantly related to beta.