Optimal Investment, Growth Options, and Security Returns

  • Author(s): Jonathan B. Berk, Richard C. Green, Vasant Naik
  • Published: Dec 17, 2002
  • Pages: 1553-1607
  • DOI: 10.1111/0022-1082.00161

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.

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