Document Type : Research Paper

Authors

• Teimur Mohammadi ¹
• Mohammad Reza Feghhi Kashani ²
• Mahdi Samei ³

¹ Professor, Faculty of Economics, Allame Tabataba’i University, Tehran, Iran

² Assistant Professor, Faculty of Economics, Allameh Tabataba’i University, Tehran, Iran.

³ Ph.D. in Financial Economics, Allameh Tabataba’i University, Tehran, Iran.

Abstract

The negative correlation between an asset’s volatility and its return is known as leverage effect. This relationship is explained by the effect of a firm’s equity return on the degree of leverage in its capital structure. If this relationship holds, the increased volatility resulting from a fall in stock price should be comparable with the decreased volatility resulting from a price rise with the same magnitude, and this effect should also be persistent. Most research on the leverage effect has examined the relationship between the behavior of returns and return volatility. The present study aimed to examine the relationship between return volatility, returns, and the debt ratio. The data were collected from 22 biggest companies listed on the Tehran Stock Exchange for the period from March 2009 to March 2019. The value of debt in the capital structure of the selected companies was calculated using the Geske compound option pricing model.  According to the results, the existence of an asymmetric effect on returns only during bearish market conditions, alongside the instability of this effect, indicates that the debt ratio cannot explain the behavior of returns and return volatility.
1.Introduction
Extensive research on return volatility and its modeling reflects the considerable attention and importance this topic holds within various financial domains. The sheer number of scientific inquiries into volatility modeling and prediction underscores its significance in financial discourse, playing a pivotal role in both theoretical and empirical realms (Kambouroudis et al., 2021). Uncovering the influential factors affecting return volatility and gaining insights into their impact can contribute to a deeper understanding of return volatility. The leverage effect, which denotes the negative relationship between an asset’s return and its return volatility, suggests that as an asset’s return increases, its volatility decreases and vice versa. A common explanation attributes the divergent behavior of stock returns and return volatility to the debt ratio in a company’s capital structure  (Aït-Sahalia et al., 2013). When a company’s value increases, assuming the debt value remains stable, the relative return on equity will rise more than the overall company return because the total stock value is less than the total company value. Therefore, equity in a company with a higher debt ratio will exhibit greater volatility compared to the overall company, with this difference depending on the equity ratio in the company’s capital structure. This relationship with the debt ratio also leads to a systemic and inverse change in equity return volatility relative to its own return. When negative stock returns lead to a decrease in equity value relative to the fixed amount of debt, the debt ratio increases, resulting in an anticipated increase in stock volatility in the future. Conversely, positive stock returns are expected to have the opposite effect. The market value of a company’s equity affects the value of its debt. This research aimed to examine the ability of debt ration to explain the observed leverage effect. Therefore, accurately estimating the debt ratio and the value of the debt is crucial. In this line, the present inquiry investigated the relationship between stock return volatility and the debt ratio in the case of companies listed on the Tehran Stock Exchange.
2.Materials and Methods
This study used the model proposed by Figlewski and Wang (2000) in order to investigate the leverage effect. A distinctive aspect of the current research lies in the calculation of the debt value and the debt ratio using the Geske compound options pricing model (Geske, 1979).
The sample of the study consisted of 22 non-banking companies selected from the top 30 listed on the Tehran Stock Exchange. Seven banking symbols and one symbol with insufficient information were excluded from the analysis. Banking symbols were excluded due to the unique nature of the banking business, which significantly influences debt performance (Damodaran, 2013). Data on prices, number of shares, and debt structure for these companies were systematically collected from 2009 to 2019. The study relied on quantile regression as the analytical approach. Quantile regression is particularly robust in scenarios where errors deviate from a normal distribution or outliers are present in the data. This method allows for model estimation without being constrained  by assumptions typical in ordinary regression, such as homoscedasticity and the influence of outliers on coefficient estimation.
3.Results and Discussion
If the leverage effect, characterized by the negative relationship between return volatility and stock returns, were solely due to returns influencing the debt ratio, one would expect this effect to be consistent across positive and negative returns. Additionally, assuming the effect of returns on the debt ratio remains stable over time, one would anticipate a stable effect on return volatility as well. The findings indicated asymmetric effects of returns on return volatility, with a notable difference between positive and negative returns. Moreover, over time, both the magnitude and significance of this effect diminish. Another objective was to explore the direct effect of the debt ratio on return volatility. Similar to the previous case, the data suggested differing effects of the debt ratio during upward and downward trends. When the debt ratio increases due to declining returns, there is a consistent relationship observed between return volatility and the debt ratio. Conversely, during upward trends, the relationship between the debt ratio and return volatility is inverse. Furthermore, in assessing the stability of the effect of debt ratio on return volatility, the coefficients of lagged debt ratios were not significant, with only the coefficient of the current period’s debt ratio showing meaningful impact over the study duration.
4.Conclusion
According to the results, if a leverage effect exists, it manifests primarily in bearish market conditions (associated with an increasing debt ratio), and this effect is not stable over time. Consequently, the debt ratio alone cannot fully explain the relationship between return behavior and return volatility.

Keywords

• Leverage Effect
• Debt Ratio
• Compound Option
• Return Volatility

Main Subjects

• Financial Economics