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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.

Suggested Citation

  • Ai, Hengjie & Kiku, Dana, 2013. "Growth to value: Option exercise and the cross section of equity returns," Journal of Financial Economics, Elsevier, vol. 107(2), pages 325-349.
  • Handle: RePEc:eee:jfinec:v:107:y:2013:i:2:p:325-349
    DOI: 10.1016/j.jfineco.2012.08.009
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    Cited by:

    1. José L. Fillat & Stefania Garetto, 2015. "Risk, Returns, and Multinational Production," The Quarterly Journal of Economics, Oxford University Press, vol. 130(4), pages 2027-2073.
    2. repec:oup:restud:v:84:y:2017:i:3:p:1306-1345. is not listed on IDEAS
    3. Fukuta, Yuichi & Yamane, Akiko, 2015. "Value premium and implied equity duration in the Japanese stock market," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 39(C), pages 102-121.
    4. Grüning, Patrick, 2015. "International endogenous growth, macro anomalies, and asset prices," SAFE Working Paper Series 83, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    5. Massimiliano Croce, Mariano, 2014. "Long-run productivity risk: A new hope for production-based asset pricing?," Journal of Monetary Economics, Elsevier, vol. 66(C), pages 13-31.
    6. 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.
    7. Graeme Guthrie, 2014. "Real Options And The Cross-Section Of Expected Stock Returns," Journal of Economic Surveys, Wiley Blackwell, vol. 28(2), pages 265-283, April.
    8. Lu Zhang & Howard Kung & Hang Bai, 2013. ""Shooting" the CAPM," 2013 Meeting Papers 905, Society for Economic Dynamics.
    9. Hang Bai & Kewei Hou & Howard Kung & Lu Zhang, 2015. "The CAPM Strikes Back? An Investment Model with Disasters," NBER Working Papers 21016, National Bureau of Economic Research, Inc.
    10. repec:eee:dyncon:v:78:y:2017:i:c:p:118-148 is not listed on IDEAS
    11. Zhongjun Qu & Denis Tkachenko, 2017. "Global Identification in DSGE Models Allowing for Indeterminacy," Review of Economic Studies, Oxford University Press, vol. 84(3), pages 1306-1345.
    12. Chen, Andrew Y., 2014. "Habit, Production, and the Cross-Section of Stock Returns," Finance and Economics Discussion Series 2014-103, Board of Governors of the Federal Reserve System (U.S.).

    More about this item

    Keywords

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

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • E20 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)

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