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Growth Options in General Equilibrium: Some Asset Pricing Implications

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  • Julien Hugonnier

    ()
    (University of Lausanne and FAME)

  • Erwan Morellec

    ()
    (University of Lausanne, FAME and CEPR)

  • Suresh Sundaresan

    ()
    (Graduate School of Business, Columbia University)

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    Abstract

    We develop a general equilibrium model of a production economy which has a risky production technology as well as a growth option to expand the scale of the productive sector of the economy. We show that when confronted with growth options, the representative consumer may sharply alter consumption rates to improve the likelihood of investment. This reduction in consumption is accompanied by an erosion of the option value of waiting to invest, leading to investment near the zero NPV threshold. It also has important consequences for the evolution of risk aversion, asset prices and equilibrium interest rates which we characterize in this paper. One interesting prediction of the model is that we get time varying risk aversion and equity returns by virtue of the presence of growth option. We also find that the moneyness of the growth option is the key factor which determines the extent to which the book to market ratios will influence the conditional moments of equity returns.

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    Bibliographic Info

    Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp138.

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    Date of creation: Mar 2005
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    Handle: RePEc:fam:rpseri:rp138

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    Keywords: Time varying MRS; Growth Options; General Equilibrium;

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    References

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    1. Wang, Tan, 2001. "Equilibrium with new investment opportunities," Journal of Economic Dynamics and Control, Elsevier, vol. 25(11), pages 1751-1773, November.
    2. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
    3. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
    4. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
    5. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
    6. Jaime Casassus & Pierre Collin-Dufresne & Bryan R. Routledge, . "Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technologies," GSIA Working Papers 2004-E54, Carnegie Mellon University, Tepper School of Business.
    7. Gomes, Joao F & Kogan, Leonid & Zhang, Lu, 2002. "Equilibrium Cross-Section of Returns," CEPR Discussion Papers 3482, C.E.P.R. Discussion Papers.
    8. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
    9. R. Glenn Hubbard, 1994. "Investment under Uncertainty: Keeping One's Options Open," Journal of Economic Literature, American Economic Association, vol. 32(4), pages 1816-1831, December.
    10. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
    11. Mark Rubinstein, 1976. "The Valuation of Uncertain Income Streams and the Pricing of Options," Bell Journal of Economics, The RAND Corporation, vol. 7(2), pages 407-425, Autumn.
    12. Kogan, Leonid, 2001. "An equilibrium model of irreversible investment," Journal of Financial Economics, Elsevier, vol. 62(2), pages 201-245, November.
    13. Sundaresan, Suresh M, 1989. "Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 73-89.
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    Cited by:
    1. Jermann, Urban J., 2010. "The equity premium implied by production," Journal of Financial Economics, Elsevier, vol. 98(2), pages 279-296, November.

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