Optimal Investment, Growth Options, and Security Returns

Posted: 17 Aug 1999

See all articles by Richard C. Green

Richard C. Green

Carnegie Mellon University - David A. Tepper School of Business

Jonathan Berk

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Vasant Naik

Lehman Brothers International, Europe

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Abstract

As a consequence of optimal investment choices, firms' assets and growth options change in predictable ways. Using a dynamic model, we show that this imparts predictability to changes in a firm's systematic risk, and its expected return. Simulations show that the model simultaneously reproduces: (i) the time series relation between the book-to-market ratio and asset returns, (ii) the cross-sectional relation between book to market, market value and return, (iii) contrarian effects at short horizons, (iv) momentum effects at longer horizons, and (v) the inverse relation between interest rates and the market risk premium.

JEL Classification: G12, G31, E22

Suggested Citation

Green, Richard C. and Berk, Jonathan B. and Naik, Vasant, Optimal Investment, Growth Options, and Security Returns. Journal Of Finance, Vol. 54, No. 5, October 1999. Available at SSRN: https://ssrn.com/abstract=160189

Richard C. Green

Carnegie Mellon University - David A. Tepper School of Business ( email )

315B Schenley Park
Pittsburgh, PA 15213-3890
United States
412-268-2302 (Phone)
412-268-7064 (Fax)

Jonathan B. Berk (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Vasant Naik

Lehman Brothers International, Europe ( email )

25 Bank Street
30th Floor
London E14 5LE
England

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