Leverage Cycles Driving Asset Prices

This work investigates the question whether the borrowing capacity of investors, defined as leverage, has a positive impact in the pricing of assets as hypothesized by the leverage cycle theory of Geanakoplos (2010a). Therefore, two different measures of leverage based on broker-dealer balance sheet data and US primary dealer repo financing data are introduced in order to approximate the borrowing capacity of investors. The empirical analysis is conducted using a leverage augmented Fama-French four-factor model for the US stock market. The results suggest that the borrowing capacity of investors is a priced risk factor for individual sub-portfolios whereas its economical significance is considerably lower compared to the established Fama-French risk factors. Furthermore, the inclusion of leverage as an additional risk factor adds marginal explanatory power to the model. The results are consistent with the growing body of empirical literature and suggest further analyses of the role of leverage in asset pricing.