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Optimal Investment, Growth Options, and Security Returns

  • Jonathan B. Berk

    (University of California, Berkeley, and NBER,)

  • Richard C. Green

    (Carnegie Mellon University,)

  • Vasant Naik

    (University of British Columbia)

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. Copyright The American Finance Association 1999.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 54 (1999)
Issue (Month): 5 (October)
Pages: 1553-1607

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Handle: RePEc:bla:jfinan:v:54:y:1999:i:5:p:1553-1607
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