Asset Variance Risk Premium and Capital Structure

Babak Lotfaliei

This paper investigates how the asset-return variance risk premium changes leverage. I find that the premium reduces leverage by increasing risk-neutral bankruptcy probability and costs in a model where asset returns have stochastic variance with the risk premium. Empirically, the model calibrations verify significant reduction in optimal leverage, closer to observed leverage than the model without the premium. In model-free regressions, I document that leverage correlates negatively with the variance premium. Highest negative correlation is among investment-grade firms with low asset beta and historical variance but high variance premiums because their assets have high exposure to the market’s variance premium.

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