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Investment, idiosyncratic risk, and growth options

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  • Liu, Clark
  • Wang, Shujing

Abstract

We provide evidence that growth options play an important role in determining the negative relation between corporate investment and idiosyncratic risk in the absence of agency problem. A simple real options model predicts that the negative relation between corporate investment and idiosyncratic risk is a U-shaped function of the level of idiosyncratic risk: investment responds the most when idiosyncratic risk is at the intermediate level. And the negative relation is stronger when firms possess more growth options. Our results are robust when we control for the effect of managerial risk aversion, supporting the view that firms’ optimal response to uncertainty is an important driving force behind the negative investment–idiosyncratic risk relation.

Suggested Citation

  • Liu, Clark & Wang, Shujing, 2021. "Investment, idiosyncratic risk, and growth options," Journal of Empirical Finance, Elsevier, vol. 61(C), pages 118-138.
    • Handle: RePEc:eee:empfin:v:61:y:2021:i:c:p:118-138
    DOI: 10.1016/j.jempfin.2021.01.004
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    4. Liu, Clark & Wang, Shujing & Wei, K.C. John, 2021. "Demand shock, speculative beta, and asset prices: Evidence from the Shanghai-Hong Kong Stock Connect program," Journal of Banking & Finance, Elsevier, vol. 126(C).

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    More about this item

    Keywords

    Investment; Idiosyncratic risk; Growth options; Agency problem; Managerial risk aversion;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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