Optimal Investment, Growth Options, and Security Returns
Richard C. Green
Carnegie Mellon University - David A. Tepper School of Business
Stanford University - Graduate School of Business; National Bureau of Economic Research (NBER)
Lehman Brothers International, Europe
Journal Of Finance, Vol. 54, No. 5, October 1999
As a consequence of optimal investment choices, firms' assets and growth options change in predictable ways. Using a dynamic model, we show that this imparts predictability to changes in a firm's systematic risk, and its expected return. Simulations show that the model simultaneously reproduces: (i) the time series relation between the book-to-market ratio and asset returns, (ii) the cross-sectional relation between book to market, market value and return, (iii) contrarian effects at short horizons, (iv) momentum effects at longer horizons, and (v) the inverse relation between
interest rates and the market risk premium.
JEL Classification: G12, G31, E22Accepted Paper Series
Date posted: August 17, 1999
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