Many industries or businesses need additional resources for growth, but sometime, there is lack of capital to get additional resources. In order to get additional resources, the company go for debt to acquire additional resources, this is called financial leverage or trading on equity. These are different kinds of financial instruments or the borrowed capital which may be used for the purpose of increasing the overall return on the investment. Once the company is leveraged, its volatility increases as the stock price moves lower and closer to the level of debt. The overall impact of the leverage may refer to the well-established relationship which may be there between the different stock returns. Both of them implies and realizes the volatility– this happens with the increase in volatility with the fall of the stocks of the company .This leverage effect relates to the phenomenon which may include the overall change that is observed which is their market valuation of the equity of the firm due to the higher degree of leverage in the structure of its overall capital and the increase in the overall leverage which can be used in producing the increase in the overall stock volatility.
In order to explain leverage effect, both returns and directly measure leverage are used. With the falling prices of the stocks, there is a strong leverage effect associated. The leverage account may be recognized whenever the value of stock volatility is negatively related to the stock returns. This is because the stock volatility may tend to increase whenever there is a drop in stock prices. In addition to this, whenever there is an increase in the volatility with the drop of the stock prices. Majorly, the leverage effect is explained based on two economic bases. The first basis is relationship between volatility and expected returns as explained above. On the other side, the second economic explanation is based on financial leverage that affects the stock price. When the stock price falls, financial leverages on the company increase. This leads to the overall increase in the return volatility of the stock. Various empirical studies indicate that financial leverage has mixed results and these studies face several difficulties.