Labor Leverage, Financial Leverage, and the Dissection of Expected Returns

We show, both theoretically and empirically, how labor and financial leverage interact and jointly explain the risk and return of corporate securities. We embed capital structure decisions into a production-based asset pricing model of labor leverage. We test the predictions of the model using a unique dataset of bond and asset returns. We find that (i) financial leverage is positively related to bond returns, negatively related to asset returns, and unrelated to stock returns, (ii) labor leverage amplifies asset, bond, and stock risk, and (iii) it is the unlevered portion of asset risk, as opposed to the asset risk amplification by labor leverage, that explains most of cross-sectional variation in financial leverage ratios.