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Stochastic idiosyncratic cash flow risk and real options: implications for stock returns

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Title: Stochastic idiosyncratic cash flow risk and real options: implications for stock returns
Authors: Bhamra, HS
Shim, K
Item Type: Journal Article
Abstract: Stocks with high idiosyncratic volatility perform poorly relative to low idiosyncratic volatility stocks. We o ↵ er a novel explanation of this anomaly based on real options, which is consistent with earlier findings on idiosyncratic volatility (the positive contemporaneous relation between firm-level stock returns and idiosyncratic volatility). Our approach is based on introducing stochastic idiosyncratic cash flow risk into an equity valuation model of firms with growth options. Within our model, a firm’s systematic risk depends on the delta of its growth op- tion. The growth option’s delta is lower when idiosyncratic volatility rises, driving down the firm’s systematic risk and hence its expected return – firms with higher idiosyncratic volatility therefore have lower expected returns. Our model additionally o ↵ ers the following novel em- pirical predictions: (i) returns correlate positively with idiosyncratic volatility during intervals between large changes in idiosyncratic volatility (the switch e ↵ ect), and (ii) the anomalies and the switch e ↵ ect are stronger for firms with more real options and which undergo larger changes in idiosyncratic volatility. Empirical results support the predictions of our model.
Issue Date: 11-Jan-2017
Date of Acceptance: 25-Nov-2016
URI: http://hdl.handle.net/10044/1/42733
DOI: https://dx.doi.org/10.1016/j.jet.2016.11.005
ISSN: 0022-0531
Publisher: Elsevier
Start Page: 400
End Page: 431
Journal / Book Title: Journal of Economic Theory
Volume: 168
Copyright Statement: © 2017 Elsevier Inc. All rights reserved. This manuscript is licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International http://creativecommons.org/licenses/by-nc-nd/4.0/
Keywords: Social Sciences
Economics
Business & Economics
Asset pricing
Stock return and idiosyncratic volatility
Real options
Stochastic volatility
Regime-switching
Mixed jump-diffusion
ASSET PRICE DYNAMICS
CROSS-SECTION
IRREVERSIBLE INVESTMENT
CORPORATE-INVESTMENT
CAPITAL STRUCTURE
SECURITY RETURNS
FIRM
PERFORMANCE
UNCERTAINTY
VOLATILITY
Economic Theory
1401 Economic Theory
Publication Status: Published
Appears in Collections:Imperial College Business School