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Growth to value: Option exercise and the cross section of equity returns

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  • Ai, Hengjie
  • Kiku, Dana

Abstract

We propose a general equilibrium model to study the link between the cross section of expected returns and book-to-market characteristics. We model two primitive assets: value assets and growth assets that are options on assets in place. The cost of option exercise, which is endogenously determined in equilibrium, is highly procyclical and acts as a hedge against risks in assets in place. Consequently, growth options are less risky than value assets, and the model features a value premium. Our model incorporates long-run risks in aggregate consumption and replicates the empirical failure of the conditional capital asset pricing model (CAPM) prediction. The model also quantitatively accounts for the pattern in mean returns on book-to-market sorted portfolios, the magnitude of the CAPM-alphas, and other stylized features of the cross-sectional data.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 107 (2013)
Issue (Month): 2 ()
Pages: 325-349

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Handle: RePEc:eee:jfinec:v:107:y:2013:i:2:p:325-349

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Web page: http://www.elsevier.com/locate/inca/505576

Related research

Keywords: Value premium; Real options; General equilibrium; Long-run risks; Firm dynamics;

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References

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Cited by:
  1. Jerry Tsai & Jessica A. Wachter, 2014. "Rare Booms and Disasters in a Multi-sector Endowment Economy," NBER Working Papers 20062, National Bureau of Economic Research, Inc.
  2. Lu Zhang & Howard Kung & Hang Bai, 2013. ""Shooting" the CAPM," 2013 Meeting Papers 905, Society for Economic Dynamics.

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