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Using Leverage as a Risk Factor in Explaining the Cross Section of Stock Returns

Leverage is an important risk factor which has been ignored in the asset pricing literature. This paper attempts to broaden the focus of the current asset pricing literature by forming portfolios mimicking the leverage factor. Leverage is a vital risk factor that explains stock returns. We also undertake several robustness checks. We employ three models of performance measurement including the CAPM, the Fama-French three factor model and Fama- French-Carhart four factor model. We construct a five factor model using an additional factor mimicking portfolio for leverage. Our five factor model explains the variations in stock returns better relative to the other asset pricing models.