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Levered Returns


  • Gomes is from the Wharton School, University of Pennsylvania and Schmid is from the Fuqua School of Business, Duke University. Acting Editor: Jonathan Berk. We have benefited from helpful comments from Bernard Dumas, John Heaton, Urban Jermann, Dimitris Papanikolaou, James Park, Krishna Ramaswamy, Michael Roberts, Moto Yogo, and seminar participants at BI School, Boston University, Carnegie Mellon University, Copenhagen Business School, Duke University, George Washington University, Imperial College, HEC Montreal, HEC Paris, INSEAD, McGill University, NHH Bergen, Ohio State University, Tilburg University, University of North Carolina, University of South Carolina, University of Rochester, and Wharton School, as well as the NBER Asset Pricing Meeting, Duke-UNC Asset Pricing Conference, Western Finance Association, Society for Economic Dynamics, and Econometric Society. We are particularly grateful to Lorenzo Garlappi and Hong Yan for their detailed feedback and comments. Any remaining errors are our own. Schmid gratefully acknowledges financial support from Swiss National Centre of Competence in Research “Financial Valuation and Risk Management” (NCCR FINRISK) and the Fondation François et Nicolas Grandchamp.


This paper revisits the theoretical relation between financial leverage and stock returns in a dynamic world where both corporate investment and financing decisions are endogenous. We find that the link between leverage and stock returns is more complex than static textbook examples suggest, and depends on the investment opportunities available to the firm. In the presence of financial market imperfections, leverage and investment are generally correlated so that highly levered firms are also mature firms with relatively more (safe) book assets and fewer (risky) growth opportunities. A quantitative version of our model matches several stylized facts about leverage and returns.