Back to Basics: The Impact of Financial Leverage on Asset Pricing (Job Market Paper)

for helpful comments and discussions. This paper examines the impact of financial leverage on time-varying betas and on the condi-tional CAPM using a framework in which a firm’s equity beta is decomposed into the product of financial leverage and its asset beta. The unique aspect of this analysis is that a firm’s asset beta is estimated using asset returns constructed from market data not only on equity, but also on cor-porate bonds and loans. Several results emerge. The first finding is that leverage alone can explain a substantial portion of the well-documented unconditional alphas of book-to-market–sorted port-folios. Second, this improvement is shown to be due to the tight link between book-to-market and leverage, explaining my empirical finding that firms ’ asset returns do not increase across book-to-market–sorted portfolios. Third, I document that high book-to-market firms have counter-cyclical asset betas, further improving the fit of the model. In summary, high book-to-market firms have both high leverage and high asset betas in economic downturns and, therefore, have high expected equity returns.