FIN-00-037
Is the "Leverage Effect" a Leverage Effect?
November 6, 2000
Stephen Figlewski and Xiaozu Wang
ABSTRACT
The "leverage effect" refers to the well-established relationship between stock returns and both
implied and realized volatility: volatility increases when the stock price falls. A standard explanation ties the
phenomenon to the effect a change in market valuation of a firm's equity has on the degree of leverage in its capital
structure, with an increase in leverage producing an increase in stock volatility. We use both returns and directly
measured leverage to examine this hypothetical explanation for the "leverage effect" as it applies to
the individual stocks in the S&P100 (OEX) index, and to the index itself. We find a strong "leverage effect"
associated with falling stock prices, but also numerous anomalies that call into question leverage changes as the
explanation. These include the facts that the effect is much weaker or nonexistent when positive stock returns
reduce leverage; it is too small with measured leverage for individual firms, but much too large for OEX implied
volatilities; the volatility change associated with a given change in leverage seems to die out over a few months;
and there is no apparent effect on volatility when leverage changes because of a change in outstanding debt or
shares, only when stock prices change. In short, our evidence suggests that the "leverage effect" is
really a "down market effect" that may have little direct connection to firm leverage.
Stephen Figlewski
Institution: Stern School of Business, New York University
Email: sfiglews@stern.nyu.edu
Telephone: (212) 998-0712
Xiaozu Wang
Institution: City University of Hong Kong
Email: xiaozu.wang@cityu.edu.hk
Telephone: (852) 2788-7407
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