The Impact of Leverage on Return-Volatility Relationship -An Empirical Study of the Nordic Equity Markets

Abstract

Prior studies have documented mixed evidence regarding the relationship between stock returns and equity return volatilities. The purpose of this thesis is to contribute to the debate about the direction of the risk-return relationship and to seek further explanation for this phenomenon. The aim of this thesis is therefore two-fold. Firstly, it examines the risk-return relationship in the Nordic stock markets. Secondly, it seeks to explain the impact of leverage on risk-return relation using a range-based measure of volatility. Different estimation techniques are applied on both cross-sectional and panel data in order to enhance robustness of the results. After controlling for size, value, momentum factors, variation across industry and over time, as well as a number of firm-level characteristics, the regression results suggest a positive and statistically significant relationship between (range-based) volatilities and stock returns in the Nordic equity markets. The conclusion is that low volatility effect that has been documented in international stock markets does not prevail in the Nordic equity markets. Additionally, the regression results show that low leverage firms not only have higher volatility but also higher return although the leverage-return relationship has somewhat weaker statistical significance. While Dutt et al. (2013) suggest that operating performance might explain why low volatility stocks in developed and emerging equity markets outside North America generate higher returns, the findings of this thesis indicate that leverage has a negative impact on the risk-return relation. Therefore, a firm’s financial leverage could be an additional explanation to the positive risk-return relationship that is present in the Nordic equity markets.