Research Summary
Research Summary
Do Equity Covariances Reflect Financial Leverage?
Description
No arbitrage option pricing theory and the efficient market hypothesis predict that firms with higher financial leverage should have higher equity betas, all else equal. This paper finds little support in the data for this prediction. Within industry, there is large cross sectional variation in financial leverage. However, firms with high (low) financial leverage do not necessarily have high (low) equity betas. In fact, the relationship between equity beta and financial leverage is in the opposite direction from what is expected for approximately half of the industries.