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Real Options and Risk Dynamics

Review of Economic Studies, Forthcoming

60 Pages Posted: 19 Nov 2010 Last revised: 12 Apr 2015

Dirk Hackbarth

Boston University Questrom School of Business

Timothy C. Johnson

University of Illinois at Urbana-Champaign

Date Written: March 27, 2015

Abstract

We examine the asset pricing implications of a neoclassical model of repeated investment and disinvestment. Prior research has emphasized a negative relation between productivity and equity risk that results from operating leverage when capital adjustment is costly. In general, however, expansion and contraction options affect risk in the opposite direction: they lower equity risk as profitability declines. The general prediction is a nonmonotonic overlay of opposing real option and operating leverage effects. For parameters chosen to match empirical firm characteristics, the predicted nonmonotonicities are quantitatively important, and are detectable in the data. The calibrated model implies that real option effects dominate operating leverage effects, and the average firm is best described by an increasing risk profile, a conclusion supported by conditional beta estimates. The baseline calibration helps explain the profitability premium in the cross-section, but makes the value puzzle worse. Panels with heterogeneous firms can deliver simultaneous profitability and value effects that match empirical levels.

Keywords: real options, adjustment costs, risk premia

JEL Classification: D31, D92, G12, G31

Suggested Citation

Hackbarth, Dirk and Johnson, Timothy C., Real Options and Risk Dynamics (March 27, 2015). Review of Economic Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1710834 or http://dx.doi.org/10.2139/ssrn.1710834

Dirk Hackbarth

Boston University Questrom School of Business ( email )

Department of Finance
595 Commonwealth Avenue
Boston, MA 02215
United States
(617) 358-4206 (Phone)
(617) 353-6667 (Fax)

HOME PAGE: http://people.bu.edu/dhackbar/

Timothy C. Johnson (Contact Author)

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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