Real Options, Product Market Competition, and Asset Returns

Authors

  • FELIPE L. AGUERREVERE

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    • University of Alberta School of Business. I thank Antonio Bernardo, Michael Brennan, Pascal Francois, Bruno Gerard, Mark Huson, Aditya Kaul, David McLean, David Robinson, Eduardo Schwartz, Gordon Sick, Robert Stambaugh (the editor), Avanidhar Subrahmanyam, Akiko Watanabe, two anonymous referees, and seminar participants at the 2005 Alberta/Calgary Finance Conference, the 2005 Northern Finance Association Conference, the 2006 Real Options Conference at Columbia University, the 2006 Western Finance Association Meetings, and Instituto de Estudios Superiores de Administracion for helpful comments and suggestions. Support for this project from the University of Alberta SAS fellowship is gratefully acknowledged. I especially thank an anonymous referee for insights that have greatly improved the quality of this paper. All remaining errors are my own.


ABSTRACT

We study how competition in the product market affects the link between firms' real investment decisions and their asset return dynamics. In our model, assets in place and growth options have different sensitivities to market wide uncertainty. The strategic behavior of market participants influences the relative importance of these components of firm value. We show that the relationship between the degree of competition and assets' expected rates of return varies with product market demand. When demand is low, firms in more competitive industries earn higher returns, whereas when demand is high firms in more concentrated industries earn higher returns.

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