The effect of leverage mimicking portfolios in explaining stock returns variations

Abstract

Purpose

The purpose of this paper is to explore the effect of leverage mimicking factor portfolios in explaining stock return variations. This paper broadens the focus of the current asset pricing literature by forming portfolios mimicking the leverage factor.

Design/methodology/approach

Following Fama and French's and Carhart's procedure in forming size, book‐to‐market and momentum mimicking portfolios, the authors of this paper form leverage mimicking factor portfolios to explain stock returns. A five factor model is constructed that explains the variations in stock returns better relative to the other asset pricing models including the Fama‐French‐Carhart four factor model.

Findings

The findings indicate that the leverage mimicking portfolio helps to explain stock return variations better relative to the other asset pricing models including the Fama‐French‐Carhart four factor model. Results are robust to other risk factors.

Research limitations/implications

The results lead us to explore further avenues in using other risk factors in asset pricing such as future work to consider other cross‐sectional attributes such as the stochastic behaviour of earnings or profitability that might also produce common variation in stock returns. There may be other risk factors that carry a premium and thus can be used for asset pricing.

Practical implications

The paper's findings are important in fund management when selecting or evaluating portfolio performance. The authors introduce an additional factor that has a sound theoretical appeal and show that leverage mimicking factor portfolios provide additional information in pricing assets, both in the cross section of all shares and in different sectors.

Originality/value

To the best of the authors' knowledge this is the first study of the effect of leverage mimicking factor portfolios in explaining stock return variations.

Citation

Gulnur Muradoglu, Y. and Sivaprasad, S. (2013), "The effect of leverage mimicking portfolios in explaining stock returns variations", Studies in Economics and Finance, Vol. 30 No. 2, pp. 94-107. https://doi.org/10.1108/10867371311325417