Real Options and Risk Dynamics
Everett W. Lord Distinguished Faculty Scholar
Timothy C. Johnson
University of Illinois at Urbana-Champaign
March 27, 2015
Review of Economic Studies, Forthcoming
We examine the asset pricing implications of a neoclassical model of repeated investment and disinvestment. Prior research has emphasized a negative relation between productivity and equity risk that results from operating leverage when capital adjustment is costly. In general, however, expansion and contraction options affect risk in the opposite direction: they lower equity risk as profitability declines. The general prediction is a nonmonotonic overlay of opposing real option and operating leverage effects. For parameters chosen to match empirical firm characteristics, the predicted nonmonotonicities are quantitatively important, and are detectable in the data. The calibrated model implies that real option effects dominate operating leverage effects, and the average firm is best described by an increasing risk profile, a conclusion supported by conditional beta estimates. The baseline calibration helps explain the profitability premium in the cross-section, but makes the value puzzle worse. Panels with heterogeneous firms can deliver simultaneous profitability and value effects that match empirical levels.
Number of Pages in PDF File: 60
Keywords: real options, adjustment costs, risk premia
JEL Classification: D31, D92, G12, G31
Date posted: November 19, 2010 ; Last revised: April 12, 2015
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