We document that average returns to stocks are negatively related to book leverage. This relation holds in both raw returns and returns that are risk adjusted using the Fama- French (1993) factors; and it appears not to be explained by mispricing. Moreover, the financial distress risk puzzle-that returns are negatively related to default risk- disappears after controlling for leverage. Differences in accounting measures of performance indicate that the productivity of assets of high-leverage firms is less affected by financial distress than that of low-leverage firms. This is consistent with the hypothesis that the risk of bearing financial distress costs is priced, and that firms with greatest exposure to these costs rationally avoid leverage. We construct a leverage factor and show that it explains a significant common component of time series variation in returns that is distinct from those explained by the other Fama-French factors. Our results are consistent with the interpretation that book-to-market measures sensitivity to operating distress risk while leverage measures sensitivity to financial distress risk, and that both are priced in equity markets.
展开▼
