Financial Leverage and the Leverage Effect - A Market and Firm Analysis

We quantify the effect of financial leverage on stock return volatility in a dynamic general equilibrium economy with debt and equity claims. The effect of financial leverage is studied both at a market and a firm level where the firm is exposed to both idiosyncratic and market risk. In a benchmark economy with both a constant interest rate and constant price of risk, financial leverage generates little variation in stock return volatility at the market level but significant variation at the individual firm level. In an economy that generates time-variation in interest rates and the price of risk, there is significant variation in stock return volatility at the market and firm level. In such an economy, financial leverage has little effect on the dynamics of stock return volatility at the market level. Financial leverage contributes more to the dynamics of stock return volatility for a small firm.