Real Options and Risk Dynamics

Abstract:     
In a neoclassical model of a firm with repeated investment and disinvestment options, systematic risk as function of profitability describes a characteristic concave-convex graph. The non-monotonic risk profile means that good news can either raise or lower expected returns, but the response is always more positive near the exercise of the firm’s real options. The model thus implies a U-shape function for return autocorrelations, which we find in the data. The model also implies that the average slope of a firm’s expected return function depends on the reversibility of its capital. Using empirical proxies for capital adjustment costs, we find support for this predicted interaction effect, implying non-trivial differences in contraction options across firms. The average firm’s risk profile slopes upward with profitability, which is inconsistent with irreversibility. Under reversibility, good news always raises expected returns. In this case, the model may help to explain the positive profitability effect in stock returns, as well as momentum and post-event drift. We conclude that reversibility, rather than irreversibility, holds more promise for investment-based asset pricing.

Number of Pages in PDF File: 40

Keywords: real options, adjustment costs, risk premia

JEL Classification: D31, D92, G12, G31

working papers series