Lasse Pedersen
Bio sketch: Lasse H. Pedersen is the John A. Paulson Professor of Finance and Alternative Investments at the NYU Stern School of Business and a research associate at CEPR and NBER. Lasse is part of the Liquidity Working Group meeting at the Federal Reserve Bank of New York to address liquidity issues. He also serves on the New York Fed’s Monetary Policy Panel, on the Board of Directors of the American Finance Association, the Economic Advisory Boards of NASDAQ and FTSE, as a principal at AQR Capital Management, and as associate editor at The Journal of Finance, Journal of Economic Theory, and The Review of Asset Pricing Studies. His academic awards include the Fama/DFA First Prize for the best papers published in the Journal of Financial Economics. Lasse received his B.S. and M.S. from University of Copenhagen and his Ph.D. from Stanford Graduate School of Business.
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 that asset classes with embedded leverage offer low risk-adjusted returns and, in the cross-section, higher embedded leverage is associated with lower returns. A portfolio which is long low-embedded-leverage securities and short high-embedded-leverage securities earns large abnormal returns, with t-statistics of 8.6 for equity options, 6.3 for index options, and 2.5 for ETFs. We provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics.
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