Growth Options and The Cross-Section of Residual Variances

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In the data, portfolios of stocks with high average returns have low average variances.
We show that when we remove from total variance the business cycle variance as
captured by the Chen, Roll, and Ross (1986) macroeconomic factors, these stocks
actually have a larger residual variance as a fraction of total variance. This residual
variance is informative of the stock of unexercised growth options that emerge upon
arrival of embodied technological shocks. We nd that: (i) stocks with high average
returns have high residual variance and a larger stock of growth options to be
depleted; (ii) stocks with low average returns have low residual variance and have
converted most of their growth options into assets in place.

Author(s):

Andreea Mitrache    
Toulouse Business School
France