The Risk Anomaly Tradeoff of Leverage
Malcolm Baker
Harvard Business School and NBER
Jeffrey Wurgler
NYU Stern School of Business and NBER
December 14, 2014
Abstract
The “low risk anomaly” refers to the empirical pattern that apparently high-risk equities do not earn commensurately high returns. In this paper, we consider the possibility that the risk anomaly represents mispricing, not a misspecification of risk, and develop the implications for corporate capital structure. The risk anomaly generates a simple tradeoff model: Starting at zero leverage, the overall cost of capital initially falls as leverage increases equity risk. As debt becomes risky,however, the marginal benefit of increasing equity risk declines. The optimum is reached at lower leverage for firms with high asset risk. Consistent with a risk anomaly tradeoff, firms with low-risk assets choose higher leverage. In addition, leverage is inversely related to systematic
risk, holding constant total risk; a large number of firms maintain small or zero leverage despite high marginal tax rates; and many others maintain high leverage despite little tax benefit.
