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Optimal Investment, Growth Options, and Security Returns

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  • Jonathan B. Berk
  • Richard C. Green
  • Vasant Naik

Abstract

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.

Suggested Citation

  • Jonathan B. Berk & Richard C. Green & Vasant Naik, 1999. "Optimal Investment, Growth Options, and Security Returns," Journal of Finance, American Finance Association, vol. 54(5), pages 1553-1607, October.
    • Handle: RePEc:bla:jfinan:v:54:y:1999:i:5:p:1553-1607
    DOI: 10.1111/0022-1082.00161
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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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