Variance of deviation from optimal leverage

We show that deviations from the firm's target leverage are priced in the cross-section of stock returns and that the relation between these quantities is nonlinear. The concave nonlinear relation between deviation from the target leverage and next-period return is strong during economic expansions and vanishes during recessions. Our portfolio analysis provides support for the concave relation between deviation from the target leverage and next-period returns as well. We develop a factor named variance of deviation from optimal leverage (VDOL) and show that it is an important risk factor that has been omitted in the literature.