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Institutional Affiliation: University of Oxford

The Risk Anomaly Tradeoff of Leveragewith , : w22116 Higher-beta and higher-volatility equities do not earn commensurately higher returns, a pattern known as the risk anomaly. In this paper, we consider the possibility that the risk anomaly represents mispricing and develop its implications for corporate leverage. The risk anomaly generates a simple tradeoff theory: At zero leverage, the overall cost of capital falls as leverage increases equity risk, but as debt becomes riskier the marginal benefit of increasing equity risk declines. We show that there is an interior optimum and that it is reached at lower leverage for firms with high asset risk. Empirically, the risk anomaly tradeoff theory and the traditional tradeoff theory are both consistent with the finding that firms with low-risk assets choose higher leverage. More uniquely, the ris... |

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