The Impact of Financial Leverage on the Variance of Stock Returns

David Aharon,Yossi Yagil

doi:10.3390/ijfs7010014

Abstract

This paper investigates the direct theoretical relationship between the variance of stock returns (σ2E) and financial leverage (L) considering both corporate and personal taxes. Using a dataset of U.S. industrial firms, we examine the variance of stock returns as a function of the firm’s financial leverage. We demonstrate that (1) the variance of stock returns is positively related to the firm’s financial leverage, (2) the relationship between the variance of stock returns and financial leverage is positive when corporate and personal taxes are also considered, and (3) with regard to the relationship between the variance of stock returns and financial leverage, using market measures of the latter tends to generate a higher coefficient of determination and a more accurate approximation of the theoretical relationship between financial leverage and the variance of stock returns.

Highlights

Volatility, which is commonly measured by the standard deviation of stock returns, has received a great deal of attention in the literature, as it is the key factor in portfolio theory, option valuation, and asset pricing models
Volatility can be helpful for the formulation of the economic policies, rules, and regulations related to the stock market
This paper contributes to a large body of research on capital structure theory by testing the direct theoretical relationship between the variance of stock returns (σ2E) and financial leverage (L)

Summary

Introduction

Volatility, which is commonly measured by the standard deviation of stock returns, has received a great deal of attention in the literature, as it is the key factor in portfolio theory, option valuation, and asset pricing models. Volatility is important to academics, policy makers, and financial market participants. Volatility can be helpful for the formulation of the economic policies, rules, and regulations related to the stock market. Volatility has a central role in the pricing theories of derivatives. The Black-Scholes option pricing model treats volatility as the only parameter, among the strike price, time to expiration, interest rate, and stock price that must be forecasted. Academics try to identify the factors that affect the volatility of stock returns and its role in determining capital structure valuation

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