Price of Regulations: Regulatory Costs and the Cross-section of Stock Returns
49 Pages Posted: 30 Sep 2020 Last revised: 4 Mar 2021
Date Written: March 4, 2021
Regulations introduce significant fixed costs and add to operating leverage. Fixed regulatory costs that contribute to operating leverage should generate a risk premium. To explore whether such a premium exists, we introduce a measure of "regulatory operating leverage" that reflects the importance of fixed regulatory costs in a firm's cost structure. Regulatory operating leverage predicts stock returns in the cross-section, and a zero-cost high-low equal (value)-weighted regulatory operating leverage strategy generates 5.64% (5.28%) annualized risk-adjusted return. Finally, the impact of regulatory operating leverage on returns is due to the (systematic) risk contribution of fixed regulatory costs.
Keywords: Regulations, operating leverage, regulatory operating leverage, cross-section of returns, systematic risk
JEL Classification: G12, G18, G28
Suggested Citation: Suggested Citation