Leverage Bias And Risk-return Tradeoff

Under the macro environment of slowing global economic growth,China’s financial market has entered into the "new normal" development stage,and the persistent high leverage and debt burden of listed enterprises are of great concern to policy makers and scholars.Excessive leverage will not only increase the financial burden of enterprises,but also drag down the investment,consumption,and R&D innovation of the entire macro entity.Therefore,a reasonable and stable reduction of market leverage has become a top priority for China’s economic development.The premise of "deleveraging" is to understand the formation mechanism of capital structure within enterprises and its role in regulating risk,in this context,it is of great practical significance to study the interaction between enterprise capital structure and enterprise risk.Based on the reality of high leverage in China’s overall market,this thesis first empirically tests the applicability of capital structure dynamic trade-off theory in China’s financial market based on the analysis of various capital structure theories and discusses the intrinsic relationship between corporate risk changes and capital structure design.The correlation between leverage bias and stock returns is explored.Finally,the moderating effect of leverage bias on the trade-off between stock risk and return is further analyzed.The main findings of this thesis are as follows: first,the dynamic trade-off theory of capital structure(Kraus and Litzenberger,1973;Miller,1977)is more applicable to Chinese financial market than the pecking order theory(Myers and Majluf,1984)and the market timing theory(Baker and Wurgler,2002).Specifically,this thesis finds that firms are more likely to issue equity when raising external capital after an increase in risk,and tend to issue debt after a decrease in risk.Similarly,firms are more likely to reduce external capital by repurchasing debt after an increase in risk and to repurchase equity after a decrease in risk.As a result,firms that experience an increase in risk experience a downward trend in market leverage in the subsequent year compared to firms that experience a decrease in risk.This is consistent with what is predicted by trade-off theory.Second,the leverage bias variable constructed under the dynamic trade-off theory framework can effectively capture the dynamic characteristics of firms’ capital structure,and the leverage bias variable has a strong explanatory effect on stock returns.Stocks with high leverage bias have significantly higher returns than those with low leverage bias.The portfolio analysis reveals that there is a significant leverage bias premium in the market.To address the characteristics of the Chinese market,this thesis tests the leverage bias premium using the Chinese three-factor model proposed by Liu et al.(2019)for the characteristics of the Chinese market,and finds that the model still fails to explain the existence of the leverage bias premium.The relationship between leverage bias and stock returns is examined by using a series of crosssectional regression tests.The results show that leverage bias has the ability to predict future stock returns even after controlling for known firm characteristics(e.g.,size,book-tomarket ratio,momentum).Third,this thesis uses four approaches to characterize the risk of stocks: the beta of stocks relative to market volatility(β,i.e.,systematic risk),the volatility of historical returns(Ret VOL,the standard deviation of returns over the past 36 months),the idiosyncratic volatility of stocks(IVOL,the volatility of residuals in the FF-3 model),and the default risk(Merton).The correlation between risk and stock returns for different levels of leverage bias is discussed.The findings show that when a firm’s actual leverage is higher than the target leverage,the firm’s risk-return relationship is positive,i.e.,the greater the risk the greater the return.In contrast,when the actual leverage is lower than the target leverage,there is a robust and significant inverse risk-return relationship,i.e.,the higher the risk,the lower the average return.This contradicts the traditional finance view that "the higher the risk,the higher the return" and opens up new perspectives in the field of behavioral corporate finance.Compared with previous studies,the innovations of this thesis are:(1)In terms of research direction,this thesis empirically tests the applicability of different capital structure theories in China’s financial market,provides empirical evidence for the importance of dynamic trade-off theory,and constructs leverage bias variables on this basis,which clearly distills research propositions with certain theoretical depth and academic value.(2)In terms of research methodology,this thesis adopts a "diversified" approach to the independent and dependent variables in the regression equation,avoiding the phenomenon of p-hacking(pvalue manipulation)as pointed out by Mitton(2022).(3)The important impact of risk changes on firms’ capital structure is fully demonstrated by means of "specification checks".(3)From the perspective of behavioral finance,the measure of leverage bias in this thesis is based on the theoretical framework of reference-dependent preferences in prospect theory.It creates a new perspective on the anomaly between leverage bias and stock returns by creating a more effective formula and methodology from the analysis of past models of capital structure dynamics adjustment,which complements related research in the field of behavioral finance.