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REAL OPTIONS AND THE CROSS‐SECTION OF EXPECTED STOCK RETURNS
Author(s) -
Guthrie Graeme
Publication year - 2014
Publication title -
journal of economic surveys
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.657
H-Index - 92
eISSN - 1467-6419
pISSN - 0950-0804
DOI - 10.1111/joes.12011
Subject(s) - value premium , economics , stock (firearms) , profitability index , financial economics , econometrics , stock market , investment (military) , capital asset pricing model , finance , mechanical engineering , paleontology , horse , politics , political science , law , engineering , biology
This paper surveys the theoretical literature investigating the effect of firms’ investment flexibility on the cross‐section of expected stock returns. Real options analysis derives firms’ value‐maximizing investment policies as functions of exogenous fundamental drivers of profitability and calculates firms’ market values as functions of the same variables. These functions yield the relationship between expected stock returns and firm fundamentals. Several plausible explanations for the value premium – the high average stock returns earned by firms with high book‐to‐market ratios – emerge from this literature.