Embedded Leverage

Asset pricing with liquidity risk

Andrea Frazzini and Lasse Pedersen

The Review of Asset Pricing Studies, 2022, vol. 12, issue 1, 1-52

Abstract: Many financial instruments are designed with embedded leverage, such as options and leveraged exchange-traded funds (ETFs). Embedded leverage alleviates investors’ leverage constraints, and, therefore, we hypothesize that embedded leverage lowers required returns. Consistent with this hypothesis, we find empirically that options and leveraged ETFs provide significant amounts of embedded leverage; this embedded leverage increases return volatility in proportion to the embedded leverage; and higher embedded leverage is associated with lower risk-adjusted returns. The results are statistically and economically significant, and we provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics. (JEL G02, G11, G12, G13, G14, G20)

Date: 2022
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Working Paper: Embedded Leverage (2012)
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