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)

June 30, 2014

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

Abstract:     
We combine real options and stochastic idiosyncratic operating risk in an equity valuation model of firms to capture the cross-sectional variation of stock returns associated with idiosyncratic volatility. An increase in idiosyncratic risk raises the firm value due to a greater option valuation and simultaneously decreases the sensitivity of firm value to systematic risk. The model explains two empirical anomalies: the positive contemporaneous relation between stock returns and changes in idiosyncratic return volatility, and the poor performance of stocks with high idiosyncratic volatility. The 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 these predictions.

Number of Pages in PDF File: 65

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: July 1, 2014

Suggested Citation

Bhamra, Harjoat Singh and Shim, Kyung Hwan, Stochastic Idiosyncratic Operating Risk and Real Options: Implications for Stock Returns (June 30, 2014). 2013 Adam Smith Asset Pricing Conference in Oxford ; 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. 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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