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Asset Variance Risk Premium and Capital Structure

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  • Lotfaliei, Babak

Abstract

This article 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 a 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. The 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.

Suggested Citation

  • Lotfaliei, Babak, 2021. "Asset Variance Risk Premium and Capital Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 56(2), pages 647-691, March.
    • Handle: RePEc:cup:jfinqa:v:56:y:2021:i:2:p:647-691_9
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    1. Alibeiki, Hedayat & Lotfaliei, Babak, 2022. "To expand and to abandon: Real options under asset variance risk premium," European Journal of Operational Research, Elsevier, vol. 300(2), pages 771-787.

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