Investment, Idiosyncratic Risk, and Growth Options

Abstract

We provide evidence that growth options play an important role in determining the negative relation between corporate investment and idiosyncratic risk in the absence of agency problem. A simple real options model predicts that the negative relation between corporate investment and idiosyncratic risk is a U-shaped function of the level of idiosyncratic risk: investment responds the most when idiosyncratic risk is at the intermediate level. And the negative relation is stronger when firms possess more growth options. Our results are robust when we control for the effect of managerial risk aversion, supporting the view that firms' optimal response to uncertainty is an important driving force behind the negative investment-idiosyncratic risk relation.

Keywords: Investment; Idiosyncratic Risk; Growth Options; Agency Problem; Managerial Risk Aversion

JEL Classification: G31; G32