All else equal, firms with higher leverage (D/E ratio) tend to have higher betas. However, when...

All else equal, firms with higher leverage (D/E ratio) tend to have higher betas. However, when firms are heavily levered (near the “zone of insolvency” or bankruptcy), their betas tend to drop significantly. Without mentioning anything about the equation for beta, briefly explain why this phenomenon might occur.

Expert Solution

The firms with higher leverage tends to have a higher beta as the volatility related to those stocks are very high because until those firms are having a probability of Survival and reporting turnaround results, there is a huge amount of speculation about their survival and their turnaround and growth projections, so a lot of people participate and speculate about their dramatic turnaround and wait upon their survival so these all factors leads to a high volatility of the stock and since there is higher uncertainty associated with the existence of the company there is a high beta of the stock.

when firms are near the bankruptcy, the market already discounts that they are not going to survive so the uncertainty is not present around the stock and the direction has been clear that the stock is not going to survive so since there is more of the certainity about dissolution of the company, the volatility tends to decline as the market participants are clear about the future and there are certain about its non existence leading to a lower beta.

jeff jeffy answered 1 year ago

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