Can leverage effect coexist with value effect?
In this paper, we evaluate the cross sectional relationship between firm characteristics, financial leverage, and stock returns for Indian market. The study finds that there is a strong size and value effect existing in the return pattern of stocks. Further the study finds a complex pattern between leverage and stock returns in Indian context. GRS test confirm the robustness of three factor models with market, size and leverage over Fama-French three factor model in most of the cases. Wald test confirms that the effect of value and leverage are same in determining the portfolio returns in most of the cases. So, while making investment decisions along with size one should consider both the firm specific variables value and leverage as size and value alone cannot disentangle all the variation in equity returns due to firm specific productivity from the variation due to financial leverage. Further study finds that portfolios formed using size (MC) breakpoints is sensitive to the results, whereas value (P/B) and leverage (D/E) breakpoints are insensitive to the result.