When Good News Means Higher Risk. . .

Abstract

We present a model that offers a theoretical answer to the question: 'when will an increase in a stock's price lead to higher expected returns?' By viewing the firm as a portfolio of claims on future cash flow we relate the presence of increased expected returns to value (IRV) to the presence of significant growth options and low operating/financial leverage. We simulate a cross-section of our model firms and link the presence of IRV in the cross-section to firm-level observables such as revenue volatility, operating costs and the market-to-book ratio. Our simulated sample of firms also exhibits a modest amount of momentum profits which resides largely in firms with high IRV determinants. Conditional momentum strategies implemented on CRSP/COMPUSTAT firms are strongly supportive of our findings.

Keywords: Expected Returns, asset pricing, real options, momentum

JEL Classification: G12, G14