Optimal Investment, Growth Options, and Security Returns |
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Authors: | Jonathan B Berk Richard C Green & Vasant Naik |
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Institution: | University of California, Berkeley, and NBER,;Carnegie Mellon University,;University of British Columbia |
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Abstract: | As a consequence of optimal investment choices, a firm's 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. |
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