Optimal Investment, Growth Options and Security Returns

Optimal Investment, Growth Options and Security Returns

By
Jonathan B. Berk, Richard C. Green, Vasant Naik
The Journal of Finance.
1999, Vol. 54, Pages 1153-1607

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.