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Are equities real(ly) options? Understanding the size, book-to-market and earnings-to-price factors

Research output: Working paper

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Abstract

We model the value of a firm facing irreversible investment opportunities as a portfolio of real call options: options to invest and options to produce. Theory predicts that the expected return on the firm s equity is dependent on (i) the CAPM beta of the assets underlying the options; and (ii) the average elasticity of the options. The average option elasticity depends on volatility, the level of demand and the degree of excess capacity. Our analysis, based on a large scale simulation experiment, confirms these predictions. Additionally we show that the factors analyzed by Fama and French (1992) - beginning-of-period market value of equity, book-to-market equity and earnings-to-price - are strongly associated with the CAPM beta of the underlying assets, volatility, the level of demand and the degree of excess capacity. The links to (unobservable) model fundamentals provide a clear economic rationale for the Fama and French risk factors, but they do not require an appeal to the pricing of bankruptcy risk.