CAN LEVERAGE EFFECT COEXIST WITH VALUE EFFECT?

The present study evaluates the cross sectional relationship between firm characteristics, financial leverage and stock returns for the Indian stock market. The study finds that there are size and value effects existing in the return pattern of stocks similar to Balakrishnan & Maiti (2017), Maiti & Balakrishnan (2018), Maiti (2019) and others in the Indian context. Thereafter, the study results show that there exists a complex pattern between leverage and stock returns in the Indian context. Leverage pattern is observed for the small size portfolios and it fades out when size of the portfolio becomes big; whereas the in-between size portfolio shows reverse leverage pattern. The performance of both the three factor models are found to be superior to the capital asset pricing model (CAPM), similar to Balakrishnan & Maiti (2017), Maiti & Balakrishnan (2018), Maiti (2019) and others in the Indian context. The study results also confirm that a three factor model based on beta, size, and leverage is comparatively better at capturing risk-return relationship than  the Fama-French (1993) three factor model with beta, size and value. The Wald test confirms that the effect of variables LMH and L1MH1 is the same in determining the portfolio returns in most of the cases, which confirms the co-existence of both value and leverage effects in the Indian capital market.  The Gibbons, Ross, and Shanken (GRS) test confirms the robustness of the three factor model with market, size, and leverage over the Fama-French three factor model (1993) in most cases. Further, the study finds that portfolios formed using size breakpoints are sensitive to the results, but not much in the case of value and leverage breakpoints. The effect of leverage in the Indian context is very complex and hence, variables like debt to equity ratio that proxy for firm’s financial leverage have information beyond what is contained in size and value variables.