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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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    More about this item

    Keywords

    Value premium; Real options; General equilibrium; Long-run risks; Firm dynamics;
    All these keywords.

    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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