PURPOSE: Leverage is routinely described as a source of firm risk, yet the Modigliani–Miller framework suggests that debt may reallocate a given amount of operating risk to shareholders rather than creating new operating risk. Because empirical studies often proxy risk with already-leveraged measures, this distinction is rarely tested directly. This study examines whether leverage is associated with changes in underlying operating volatility, redistributes risk across claimants, and relates to insolvency distance and firm value.
DESIGN/METHODOLOGY/APPROACH: We analyse a balanced panel of 196 listed firms observed annually from 1398–1403 (2019/20–2024/25). After constructing three-year rolling standard deviations of return on assets, return on equity and Tobin’s Q, the estimation panel contains 784 firm-year observations. Pooled OLS with year fixed effects and firm-clustered standard errors is complemented by a direct second-moment test of Proposition II, between/within variance decomposition, and firm fixed-effects specifications to account for time-invariant heterogeneity. Robustness is further tested through leave-one-year-out checks and alternative two- and four-year volatility windows.
FINDINGS: Leverage is not significantly associated with asset risk but shows a strong correlation with equity risk and insolvency distance. While the Proposition II slope is statistically indistinguishable from unity, the relationship must be interpreted in light of the accounting identities between the variables. The governance index is unrelated to the four risk measures, although it is associated with firm value. Persistent firm heterogeneity explains 48.5 percent of asset-risk variation, compared with 0.9 percent for the observable baseline specification.