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Working Papers, No. 2022-42, September 2022 Crossref
Mind the Gap: The Market Price of Financial Flexibility

(Revised April 2025)

The empirical connection between financial leverage and equity risk premia is surprisingly weak. We propose a quantitative model linking limited financial flexibility to levered risk premia, where firms make dynamic investment, financing, and default decisions. The model highlights two key variables, leverage gaps and leverage targets, as drivers of risk premia. Firms partially close the gap toward their target, remaining optimally over- or under-levered. Equityholders of overlevered firms face higher debt costs, as their capital structure becomes more exposed to bankruptcy risk. As a result,leverage gaps amplify asset returns. The “lost” leverage risk premium reappears after controlling for targets.


Working papers are not edited, and all opinions and errors are the responsibility of the author(s). The views expressed do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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