How leverage can improve performance

One of the best-known Capital Asset Pricing Model (CAP/M) provides us with a methodology for measuring the relationship between the risk premium and the impact of leverage on expected returns. However, this model is not used only to value the cost of capital but also to evaluate the performance of managed portfolios. We will test how the expected return changes in percent by changing the debt-equity ratio and the tax rate based on following assumptions: market return 7%, risk-free rate of return 1% and beta 1.2. These assumptions will be constant and we will change the debt-equity ratio and tax rate. Based on these results, it is clear that the change in profitability varies, in relation to the change of the DE ratio by one tenth. As for changes I n tax rates, changes in expected profitability are not entirely in direct proportion to these changes.

Comparing Asset Pricing Models by the Conditional Hansen-Jagannathan Distance*

We compare nonnested parametric specifications of the stochastic discount factor (SDF) using the conditional Hansen–Jagannathan (HJ-) distance. This distance measures the discrepancy between a parametric model-implied SDF and the admissible SDF’s satisfying all the conditional (dynamic) no-arbitrage restrictions, instead of just few unconditional no-arbitrage restrictions for managed portfolios chosen through the instrument selection. We estimate the conditional HJ-distance by a generalized method of moments estimator and establish its large sample properties for model selection purposes. We compare empirically several SDF models including multifactor beta pricing specifications and some recently proposed SDF models that are conditionally linear in consumption growth.