Sheridan Titman
University of Texas, Austin
Atakan Yalcin
Koc University
abstract
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In accordance with the well-known Ūnancial leverage effect, decreases in stock prices cause an
increase in the levered equity beta for a given unlevered beta. However, as growth options
are more volatile and have higher risk than assets in place, a price decrease may decrease the
unlevered equity beta via an operating leverage effect. This is because price decreases are
associated with a proportionately higher loss in growth options than in assets in place. Most of
the existing literature focuses on the Ūnancial leverage effect: This paper examines both effects.
We show, with a simple option pricing model, the opposing effects at work when the Ūrm is a
portfolio of assets in place and growth options. Our empirical results show that, contrary to
common belief, the operating leverage effect largely dominates the Ūnancial leverage effect, even
for initially highly levered Ūrms with presumably few growth options. We then link variations
in betas to measurable Ūrm characteristics that proxy for the fraction of the Ūrm invested in
growth options. We show that these proxies jointly predict a large fraction of future cross-
sectional differences in betas. These results have important implications on the predictability
of equity betas, hence on empirical asset pricing and on portfolio optimization that controls for
systematic risk.
Some key words: Beta, Financial Leverage, Operating Leverage, Growth options, Assets in Place
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