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Growth to value: Option exercise and the cross section of equity returns

Hengjie Ai and Dana Kiku

Journal of Financial Economics, 2013, vol. 107, issue 2, 325-349

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.

Keywords: Value premium; Real options; General equilibrium; Long-run risks; Firm dynamics (search for similar items in EconPapers)
JEL-codes: G00 G10 G12 D53 E20 (search for similar items in EconPapers)
Date: 2013
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DOI: 10.1016/j.jfineco.2012.08.009

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Handle: RePEc:eee:jfinec:v:107:y:2013:i:2:p:325-349