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Can real options explain the skewness of stock returns?

Journal: Journal of Banking & Finance

Date: 2023

Author: Tuan Ho, Kirak Kim, Yang Li, Fangming Xu

Abstract:
We study a novel mechanism through which real options play a prominent role in inducing the skewness of stock returns. Building on the investment-based asset pricing framework, we show that firms' real options to contract (expand) their businesses when productivity is low (high) can increase return skewness. Consequently, return skewness represents a U-shaped function of firm productivity. Furthermore, the real-options effect is stronger for more flexible firms, characterized by lower scale-adjustment frictions. Employing a large sample of U.S. firms during 1972-2018, we provide a battery of robust empirical evidence consistent with the model predictions. Our findings demonstrate that firm-level real flexibility can impact investors and managers' decision making.

Link: Google Scholar

Background and Context

Research Focus

This study examines how companies' real options (ability to expand or contract operations) affect the skewness of their stock returns during 1972-2018.

Methodology

The research uses an investment-based asset pricing model incorporating options to expand and contract business operations, tested on a large sample of U.S. firms.

Key Innovation

Unlike previous studies focused on investor behavior or information disclosure, this paper reveals how firms' operational flexibility drives return skewness.

U-Shaped Relationship Between Return Skewness and Market-to-Book Ratio

  • Stock returns show a clear U-shaped pattern in their skewness across different market-to-book ratios
  • Return skewness is higher for both very low and very high market-to-book ratios
  • This pattern supports the theory that real options affect return skewness at extreme productivity levels

Impact of Real Flexibility on Return Skewness

  • More flexible firms show stronger U-shaped patterns in return skewness
  • The effect is nearly twice as strong for high-flexibility firms compared to low-flexibility firms
  • This confirms that operational flexibility amplifies the real-options effect on return skewness

Regression Analysis Results Across Different Model Specifications

  • The U-shaped relationship remains robust across different model specifications
  • The effect persists even after controlling for firm characteristics and fixed effects
  • Magnitude decreases but remains statistically significant with additional controls

Alternative Measures of Productivity and Return Skewness

  • The U-shaped relationship is robust across different measures of productivity
  • Results remain consistent when using alternative measures of return skewness
  • Confirms that the findings are not sensitive to specific measurement choices

Time Series of Sample Statistics

  • Shows the distribution of key variables across the sample period
  • Return skewness exhibits substantial variation across firms
  • Real flexibility measures show significant cross-sectional differences

Contribution and Implications

  • Reveals that firms' operational flexibility is a key driver of stock return skewness, beyond traditional explanations based on investor behavior
  • Demonstrates that return skewness is higher when firms have more flexibility to adjust their operations
  • Provides important insights for investors in portfolio construction and risk management

Data Sources

  • U-shaped relationship visualization based on Figure 6 in the article
  • Flexibility impact chart constructed using data from Table 6
  • Regression analysis results from Table 3
  • Alternative measures comparison from Table 7
  • Sample statistics from Table 1