Real Options, Volatility, and Stock Returns

Abstract

This paper provides evidence that the positive relation between firm-level stock returns and firm-level return volatility is due to real options that firms possess. Consistent with the theoretical prediction that the value of a real option should be increasing in the volatility of the underlying asset, we find that the positive volatility-return relation is much stronger for firms that are more likely to have more real options. We also find that the sensitivity of firm values to changes in volatility declines significantly after firms exercise their real options. Finally, we reconcile the aggregate-level evidence of a negative relation between returns and return volatility with the positive relation at the firm level by showing that the negative relation at the aggregate level may be due to aggregate market conditions that simultaneously affect both market returns and return volatility.

Keywords: Volatility, Risk, Stock Returns, Real Options

JEL Classification: G12, G31, G32