The Relationship between Financial Leverage and Stock Returns : An Empirical Study

Abstract

This thesis investigates how financial leverage affects equity returns across sectors on US stocks. Theory relevant to the subject suggests a positive relationship, while empirical studies have given contradictory results, with various research methods being used. Our cross-sectional regression models are based on the method developed by Fama and MacBeth (1973), and control for factors included in the CAPM, Fama French Five Factor model, and q-factor models. Our study provides evidence of how varying definitions of leverage can significantly impact the size and direction of the relationship between leverage and stock returns. Further, we find that the industry sector a company belongs to plays a role in explaining the relationship between leverage and stock returns. Our results find book leverage to be negatively related to stock returns when adjusting for factors in the CAPM, Fama-French Five Factor, and q-factor models, supporting the findings by Fama and French (1992) and Cai and Zhang (2011). Results for market leverage did, however, prove a positive relationship to stock returns when including Fama-French factors, supporting initial findings by Modigliani and Miller (1958), Hamada (1972), and Bhandari (1988). Thus, our findings show contradictory evidence of leverage being related to stock returns. A further interesting takeaway is the consistency of results for Energy and Consumer Staples, showing negative relationships between book leverage and stock returns across most regressions.