Working Paper: NBER ID: w18558
Authors: Andrea Frazzini; Lasse H. Pedersen
Abstract: Many financial instruments are designed with embedded leverage such as options and leveraged exchange traded funds (ETFs). Embedded leverage alleviates investors' leverage constraints and, therefore, we hypothesize that embedded leverage lowers required returns. Consistent with this hypothesis, we find that asset classes with embedded leverage offer low risk-adjusted returns and, in the cross-section, higher embedded leverage is associated with lower returns. A portfolio which is long low-embedded-leverage securities and short high-embedded-leverage securities earns large abnormal returns, with t-statistics of 8.6 for equity options, 6.3 for index options, and 2.5 for ETFs. We provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics.
Keywords: Embedded leverage; Required returns; Risk-adjusted returns; Financial instruments
JEL Codes: G0; G1; G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Embedded leverage (Y60) | lower required returns (G12) |
| Leverage constraints (D10) | Embedded leverage (Y60) |
| Higher embedded leverage (G32) | lower average returns (G19) |
| Long low-embedded-leverage securities and short high-embedded-leverage securities (G12) | significant abnormal returns (G14) |