“The price of regulation: regulatory costs and the cross-section of stock returns”
by Han Özsöylev
Koç University – Department of Economics
Using a novel measure of regulatory operating leverage that reflects the importance of fixed regulatory costs in firms’ cost structures, we show that regulatory operating leverage predicts returns in the cross-section, and that strategies formed by sorting on regulatory operating leverage earn significant excess returns. Our measure of regulatory operating leverage makes use of RegData 2.2, which quantifies the incidence of regulatory restrictions imposed on industries based on a text analysis of federal regulatory code. After controlling for a number of firm characteristics and risk factors, the relationship between regulatory operating leverage and future stock returns remains economically and statistically significant. Our evidence suggests that this relationship is due to the (systematic) risk contribution of fixed regulatory costs, which is most pronounced among mid-cap firms.
Keywords: Regulatory operating leverage, RegData, cross-section of stock returns, return predictability.