Abstract

http://ssrn.com/abstract=2199749
 
 

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Stochastic Idiosyncratic Operating Risk and Real Options: Implications for Stock Returns


Harjoat Singh Bhamra


University of British Columbia (UBC) - Sauder School of Business

Kyung Hwan Shim


University of New South Wales (UNSW)

April 14, 2015

2013 Adam Smith Asset Pricing Conference in Oxford
2013 China International Finance Conference in Shanghai
2013 Northern Finance Association Annual Meetings in Quebec
2013 Tel Aviv Finance Conference
2014 European Finance Association Annual Meetings in Lugano
2015 American Finance Association Annual Meetings in Boston
2015 Society for Economic Dynamics in Warsaw

Abstract:     
Stocks with high idiosyncratic volatility perform poorly relative to low idiosyncratic volatility stocks. We offer a simple explanation of this anomaly based on real options, which is consistent with earlier findings on idiosyncratic volatility (the positive contemporaneous relation between firm-level stock returns and idiosyncratic volatility). Our approach is based on introducing stochastic idiosyncratic operating risk into an equity valuation model of firms with growth options. Within our model, a firm’s systematic risk depends on the delta of its growth option. The growth option’s delta is lower when idiosyncratic volatility rises, driving down a firm’s systematic risk and hence its expected return. Our model further predicts that (i) returns correlate positively with idiosyncratic volatility during intervals between large changes in idiosyncratic volatility (the switch effect), (ii) and that the anomalies and the switch effect are stronger for firms with more real options and which undergo larger changes in idiosyncratic volatility. Empirical results support the predictions of our model.

Number of Pages in PDF File: 62

Keywords: Idiosyncratic return volatility, cross section of stock returns, asset pricing, real options, growth options, stochastic volatility, regime switching, mixed jump-diffusion processes

JEL Classification: G00, G10, G12, G13, G19, G30, G31


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Date posted: January 12, 2013 ; Last revised: April 15, 2015

Suggested Citation

Bhamra, Harjoat Singh and Shim, Kyung Hwan, Stochastic Idiosyncratic Operating Risk and Real Options: Implications for Stock Returns (April 14, 2015). 2013 China International Finance Conference in Shanghai ; 2013 Northern Finance Association Annual Meetings in Quebec ; 2013 Tel Aviv Finance Conference ; 2014 European Finance Association Annual Meetings in Lugano ; 2015 American Finance Association Annual Meetings in Boston; 2015 Society for Economic Dynamics in Warsaw. Available at SSRN: http://ssrn.com/abstract=2199749 or http://dx.doi.org/10.2139/ssrn.2199749

Contact Information

Harjoat Singh Bhamra
University of British Columbia (UBC) - Sauder School of Business ( email )
2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
Kyung Hwan Shim (Contact Author)
University of New South Wales (UNSW) ( email )
306 Level 3 ASB
UNSW Kensington Campus
UNSW Sydney, NSW 2052
Australia
61293855852 (Phone)
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