Optimal Investment, Growth Options, and Security Returns

Authors

  • Jonathan B. Berk,

    1. University of California, Berkeley
    Search for more papers by this author
  • Richard C. Green,

    1. Carnegie Mellon University
    Search for more papers by this author
  • Vasant Naik

    1. University of British Columbia
    Search for more papers by this author
    • Berk is at the University of California, Berkeley, and NBER; Green is at Carnegie Mellon University; and Naik is with the University of British Columbia. We acknowledge the research assistance of Robert Mitchell and Dave Peterson. We have benefited from and are grateful for comments by seminar participants at Berkeley, British Columbia, Carnegie Mellon, Dartmouth, Duke, Michigan, Minnesota, North Carolina, Northwestern, Rochester, Utah, Washington at St. Louis, Washington, Wharton, Wisconsin, Yale, the 1996 meetings of the Western Finance Association, and the 1997 Utah Winter Finance Conference and the suggestions from an anonymous referee and from the editor, René Stulz. We also acknowledge financial support for this research from the Social Sciences and Humanities Research Council of Canada and the Bureau of Asset Management at University of British Columbia. The computer programs used in this paper are available on this journal's web page: http://www.afajof.org

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.

Ancillary