Stochastic Idiosyncratic Cash Flow Risk and Real Options: Implications for Stock Returns

Journal of Economic Theory, Forthcoming

2015 Society for Economic Dynamics in Warsaw

2015 American Finance Association Annual Meetings in Boston

2014 European Finance Association Annual Meetings in Lugano

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

43 Pages Posted: 12 Jan 2013 Last revised: 28 Nov 2016

Harjoat Singh Bhamra

Imperial College Business School

Kyung Hwan Shim

University of New South Wales (UNSW)

Date Written: November 3, 2016

Abstract

Stocks with high idiosyncratic volatility perform poorly relative to low idiosyncratic volatility stocks. We offer a novel explanation of this anomaly based on real options, which is consistent with earlier findings on idiosyncratic volatility (the positive contemporaneous relation between firm-level stock returns and idiosyncratic volatility). Our approach is based on introducing stochastic idiosyncratic cash flow risk into an equity valuation model of firms with growth options. Within our model, a firm's systematic risk depends on the delta of its growth option. The growth option's delta is lower when idiosyncratic volatility rises, driving down the firm's systematic risk and hence its expected return - firms with higher idiosyncratic volatility therefore have lower expected returns. Our model additionally offers the following novel empirical predictions: (i) returns correlate positively with idiosyncratic volatility during intervals between large changes in idiosyncratic volatility (the switch effect), and (ii) 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 the predictions of our model.

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

Suggested Citation

Bhamra, Harjoat Singh and Shim, Kyung Hwan, Stochastic Idiosyncratic Cash Flow Risk and Real Options: Implications for Stock Returns (November 3, 2016). Journal of Economic Theory, Forthcoming; 2015 Society for Economic Dynamics in Warsaw; 2015 American Finance Association Annual Meetings in Boston; 2014 European Finance Association Annual Meetings in Lugano ; 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 . Available at SSRN: https://ssrn.com/abstract=2199749 or http://dx.doi.org/10.2139/ssrn.2199749

Harjoat Singh Bhamra

Imperial College Business School ( email )

Tanaka Building
Exhibition Rd
London, SW7 2AZ
United Kingdom

HOME PAGE: http://www.harjoatbhamra.com

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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