Predicting Systematic Risk: Implications from Growth Options

Posted: 12 Nov 2009

See all articles by Eric Jacquier

Eric Jacquier

Boston University School of Management; HEC Montreal - Department of Finance

Sheridan Titman

University of Texas at Austin - Department of Finance; National Bureau of Economic Research (NBER)

Atakan Yalcin

Ozyegin University

Date Written: May 1, 2009

Abstract

Via the well-known financial leverage effect, decreases in stock prices cause an increase in the levered equity beta for a given unlevered equity beta. However, as growth options are more volatile and have higher risk than assets in place, a price decrease may decrease the unlevered equity beta via an “operating leverage” effect. This is because decreases in prices can be associated with a proportionately higher loss in growth options than in assets in place. Most of the existing literature focuses on the financial leverage effect. This paper examines both effects. Our empirical results show that, contrary to common belief, the operating leverage effect largely dominates the financial leverage effect, even for highly levered firms that presumably have few growth options. We link variations in betas to measurable firm characteristics that proxy for the proportion of the firm invested in growth options. We show that these proxies jointly predict a large fraction of cross-sectional differences in betas. These results have important implications on the predictability of equity betas, hence on empirical asset pricing and on portfolio optimization that controls for systematic risk.

Keywords: financial leverage effect, growth options, risk

Suggested Citation

Jacquier, Eric and Titman, Sheridan and Yalcin, Atakan, Predicting Systematic Risk: Implications from Growth Options (May 1, 2009). CIRANO - Scientific Publications Paper No. 2009s-26. Available at SSRN: https://ssrn.com/abstract=1504121

Eric Jacquier (Contact Author)

Boston University School of Management ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, QC H3T 2A7
Canada

Sheridan Titman

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-232-2787 (Phone)
512-471-5073 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Atakan Yalcin

Ozyegin University ( email )

Nisantepe Mahallesi
Alemdag, Cekmekoy
Istanbul, 34794
Turkey
+90-216-564-9587 (Phone)
+90-216-564-9045 (Fax)

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