Real Options and Risk Dynamics
Boston University School of Management
Timothy C. Johnson
University of Illinois at Urbana-Champaign
January 30, 2014
In a neoclassical model of a firm with repeated investment and disinvestment options, good news can either raise or lower expected returns depending on the relative value of the real options and assets in place. When parameters are chosen to match empirical operating and return moments, we find that real option effects dominate operating leverage effects and the average firm is best described by an increasing risk function. This is inconsistent with the predictions of purely irreversible investment. The model also makes novel predictions about nonlinear effects: expected return and systematic risk are increasingly positive at both high and low values of productivity. The predictions are quantitatively important in the baseline calibration, and are supported in the data. There is also strong evidence that systematic risk increases with profitability, consistent with the calibration. Unconditionally, the model can account for most of the profitability premium in the cross section. Panels with heterogeneous firms can deliver simultaneous profitability, value, and momentum effects.
Number of Pages in PDF File: 55
Keywords: real options, adjustment costs, risk premia
JEL Classification: D31, D92, G12, G31working papers series
Date posted: November 19, 2010 ; Last revised: January 31, 2014
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