Optimal Investment, Growth Options, and Security Returns

Jonathan Berk, Richard C. Green, Vasant Naik

NBER Working Paper No. 6627
Issued in June 1998
NBER Program(s):   AP

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.

(2270 K)

Published: Journal of Finance, Vol. 54 (1999): 1553-1608.

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