Greetings
I have tested for some panel data across firms the relationships between financial leverage and liquidity and then between financial leverage and illiquidity. The estimates show a positive relationship between financial leverage and liquidity and also a positive relationship between financial leverage and illiquidity.
The question is how can I interpret the positive relationship between financial leverage and illiquidity at the time that financial leverage is also positive with liquidity?
If I may be so bad as to put a freezing cold blanket on the whol thing: Sorry
Thimk of the broker as the main player in this game. Think of it in terms of activity analysis. The input is money (via what it leverages). The output is money in the broker's poket. Ignore the American School of Economics mkythology and explore the relation of the interest rate and the volume of avtivity by each of a sample of grockerage house.
Could you please explain how you measure (1) leverage, (2) liquidity and (3) illiquidity in your regressions? That would make it much easier to find potential explanations for your surprising results.
Erik, thanks for your questions:
Leverage has been measured by debt to equity or total assets
Liquidity and liquidity have been measured by the Amihud's (2002) measures.
Some firm characteristics variables have been also included in the regression.
Hope this would clarify the issue.
Firms with higher leverage are (everything else equal) more risky. Liquidity is usually negatively related to risk (and illiquidity thus positively related to risk). The Amihud measure is a measure of illiquidity, so I would expect a positive relation between leverage and the Amihud illiquidity ratio. Is this what you find?
I'd still expect a positive relation between leverage and risk - just think of the simple leverage relation which implies that the standard deviation of the return on equity is (1 + D/E)*standard deviation of the unlevered firm. And in corporate finance we routinely lever and unlever betas in order to account for the positive relation between risk and leverage.
Following my discussion above. One question is that if I have a sample of panel data for 500 firms across a specific number of quarters for several years, how I can separate the data into two sets, for example, for firms with levered betas and for firms with unlevered betas, since sometimes some firms may have both levered and unlevered betas for the same quarter.
My understanding is that calculating levered and unlevered betas relies on each other when taking the leverage ratio into account, which gives me two separate variables for every quarter for the same firm. One variable for levered betas and the other one for unlevered betas.
If you can correct me, it would be much appreciated.
Seeking your assistance, Thanks
Hi Mohammad, your understanding is correct. Every firm has a levered beta and an unlevered beta in every quarter. The two will be different when the firm has a non-zero level of debt, and the two are equal when the firm has zero debt.
The general relation is
Beta (unlevered) = beta (levered)*(Equity / (Debt + Equity)) + beta (debt)*(Debt / (Debt + Equity))
The levered beta is also known as the equity beta. The relation above is often simplified by assuming a zero debt beta.
Thus, if you only have a levered OR an unlevered beta for a firm-quarter, you can infer the missing value. However, this requires information (or an assumption) on the debt beta of that firm.
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