Real Options, Volatility, and Stock Returns

GUSTAVO GRULLON, EVGENY LYANDRES, and ALEXEI ZHDANOV

ABSTRACT

We provide evidence that the positive relation between firm-level

stock returns and firm-level return volatility is due to firms real options.
Consistent with real option theory, we find that the positive volatilityreturn relation is much stronger for firms with more real options and
that the sensitivity of firm value to changes in volatility declines significantly after firms exercise their real options. We reconcile the evidence
at the aggregate and firm levels 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.

Gustavo Grullon is with the Jesse H. Jones Graduate School of Business, Rice Univeristy.
Evgeny Lyandres is with the School of Management, Boston University. Alexei Zhdanov is with the
University of Lausanne and Swiss Finance Institute. The authors thank Rui Abuquerque, Yakov
Amihud, Doron Avramov, Clifford Ball, Alexander Barinov, Jonathan Berk, Gennaro Bernile,
Nicolas Bollen, Jacob Boudoukh, Tim Burch, Murray Carlson, Lauren Cohen, Francois Degeorge,
Darrell Duffie, Rafi Eldor, Wayne Ferson, Amit Goyal, Dirk Hackbarth, Campbell Harvey (the Editor), Ohad Kadan, Markku Kaustia, Matti Keloharju, Timo Korkeamaki, Moshe Levy, Lubomir
Litov, Hong Liu, Roni Michaely, Barb Ostdiek, Dino Palazzo, Brad Paye, Neil Pearson, Gordon
Phillips, Lukasz Pomorski, Amir Rubin, Jacob Sagi, Dan Segal, Anjan Thakor, Yuri Tserlukevich,
Masahiro Watanabe, James Weston, Zvi Wiener, Yuhang Xing, Guofu Zhou, an associate editor,
an anonymous referee, and seminar participants at Aalto School of Economics, Hebrew University, Interdisciplinary Center Herzliya, Louisiana State University, Rice University, Texas A&M
International University, Vanderbilt University, Washington University at Saint Louis, University
of Illinois at Urbana-Champaign, University of Miami, University of Texas at San Antonio, 2008
University of British Columbia Winter Finance Conference, 2008 Rotschild Caesarea Center Conference, 2008 European Finance Association Meetings, 2011 Finance Down Under Conference, and
2011 Napa Valley Conference for helpful comments and suggestions. The authors also thank Hernan Ortiz-Molina for help with using union membership data and Sarah Diez for valuable research
assistance.

It is well established in the asset pricing literature that aggregate market returns are
negatively correlated with aggregate market volatility (e.g., French, Schwert, and
Stambaugh (1987), Campbell and Hentschel (1992), and Duffee (1995)). One possible explanation for this negative relation is the leverage effect hypothesis (e.g.,
Black (1976) and Christie (1982)), which states that when stock prices fall, firms
become more levered, raising the volatility of stock returns. Another explanation,
due to French, Schwert, and Stambaugh (1987), holds that because an increase in
systematic volatility raises risk premia and expected future stock returns, an unexpected change in (systematic) volatility is likely to reduce firm values, leading to a
negative association between volatility and contemporaneous returns.
Contrary to the evidence at the aggregate level, however, Duffee (1995) finds
that stock returns and volatility are positively correlated at the firm level. This
empirical finding has important theoretical implications because it is inconsistent
with the leverage and risk premia hypotheses, and it challenges the conventional
wisdom on the relation between volatility and asset prices.
The main contribution of our paper is twofold. First, we provide a rational
explanation for the positive contemporaneous relation between firm-level returns and
firm-level volatility documented in Duffee (1995). Second, we provide an explanation
for the difference between the aggregate volatility-return relation and the firm-level
volatility-return relation. Surprisingly, despite the importance of these issues to our
understanding of the role of volatility in asset pricing, research on these topics has
been very limited (e.g., Albuquerque (2012) and Duffee (2002)).
We hypothesize that the positive relation between firm-level returns and firmlevel volatility may be due to real options that firms possess. One of the main
implications of real options theory is that a real options value is increasing in the

volatility of an underlying process (i.e., demand volatility, cost volatility, or overall

volatility of profits). The main rationale for this relation is that since firms can
change their operating and investment decisions to mitigate the effects of bad news
(e.g., reduce production, shut down operations, defer investments) and amplify the
effects of good news (e.g., expand production, restart operations, expedite investments), an increase in the volatility of an underlying process can have a positive
effect on firm value. That is, since operating and investment flexibility increases the
convexity of firm value with respect to the value of its underlying assets, firm value
is an increasing function of volatility, due to Jensens inequality. Therefore, if real
options constitute a substantial component of firm value, then it is possible that
the positive return-volatility relation documented in Duffee (1995) is driven by the
presence of these options. We test this hypothesis empirically and find numerous
pieces of supportive evidence.
First, we examine whether the value of firms with abundant investment opportunities is more sensitive to changes in underlying volatility than the value of
assets-in-place-based firms. The more investment opportunities a firm has, the more
discretion it has with respect to the timing of its investments and hence the larger
the value of its real options. Thus, if the positive relation between returns and
changes in volatility is due to the presence of real options, whose values are increasing in volatility, then the sensitivity of firm value to volatility should be stronger
among firms with more investment opportunities. Using a battery of proxies for investment opportunities, we find that the positive contemporaneous relation between
returns and changes in volatility is very strong among firms that are likely to have
abundant investment opportunities, while it is substantially weaker among assets in
place-based firms. Specifically, we find that the volatility-return relation is stronger

among young firms, small firms, high R&D firms, and high growth firms.
Second, since the value of real options comes from the ability of firm managers to
change their decisions as new information arrives, we also investigate whether proxies
for operating flexibility can explain cross-sectional differences in the volatility-return
relation. Consistent with the prediction that volatility creates value when managers
have flexibility to alter their investment and operating decisions, we find that the
relation between volatility and stock returns is stronger among firms with fewer operational constraints (e.g., firms in non-unionized industries) and firms that appear
to be able to respond better to resolutions of uncertainty (e.g., firms with higher
convexity of value with respect to earnings and sales).
Third, we investigate how the sensitivity of firm values to changes in volatility
evolves as a firms mix of growth options and assets in place changes over time. On
the one hand, a firm develops and accumulates real options. On the other hand, it
exercises these options by investing when the value of the benefits from investing
is high enough to offset the value of the option to wait. Thus, the sensitivity of
firm value to changes in volatility is expected to be increasing as the firm builds
up its real options, and it is expected to decline when the firm exercises (part of)
them. To test this prediction, we use spikes in firms investment levels, issues of
seasoned equity, and spikes in external financing in general to proxy for instances
of real option exercises. Consistent with the theory, we find that the sensitivity of
firm value to changes in underlying volatility increases prior to real option exercises,
drops sharply following exercises of real options, and then starts rising again as firms
start to build up new real options. This evidence strongly suggests that part of the
positive relation between returns and volatility is driven by the effect of volatility
on the value of real options.

Fourth, we demonstrate that the volatility-return relation is much stronger in

industries that have been shown to have plenty of growth and strategic options (hightech, pharmaceutical, and biotechnology industries) and high levels of operating
flexibility (natural resources industry). Furthermore, we perform a within-industry
analysis using a sample of oil and gas firms to investigate more deeply the effect
of volatility on stock returns. We focus on oil and gas firms because they provide
a unique setting for testing the predictions of the real options theory. Since these
firms have valuable timing options on developing their undeveloped proven reserves,
one could use their undeveloped and developed reserve estimates as proxies for their
mix of real options and assets in place. Using hand-collected data on oil and gas
firms reserves, we find that, consistent with the theory, the return-volatility relation
is stronger among firms with a higher proportion of undeveloped reserves.
In addition, we examine the effect of the return-volatility relation on the performance of asset pricing models. Based on the insights of McDonald and Siegel
(1985) and Berk, Green, and Naik (1999), Da, Guo, and Jagannathan (2012) argue
that in the presence of real options, the CAPM may explain the expected returns
on a firms underlying assets but not necessarily the expected returns on its equity.
This is because when firms possess real options, equity risk becomes a nonlinear
function of the risk of the underlying assets. Consistent with this argument, Da,
Guo, and Jagannathan (2012) show that the presence of real options seems to explain the poor performance of the CAPM. We exploit this result to test our main
hypothesis. If real options are an important determinant of the positive relation
between volatility and stock returns, then the CAPM, or any asset pricing model
that does not account for real options, should perform better for firms with a weak
return-volatility relation (firms with relatively few real options) than for firms with

a strong return-volatility relation (firms with abundant real options). Our empirical results are consistent with the real options theory. Using Gibbons, Ross, and
Shankens (1989) test, we find that the CAPM, as well as Fama and French (1993)
three-factor model, cannot be rejected within a subsample of firms with a relatively
weak return-volatility relation, but the models are comfortably rejected within a
subsample of firms with a relatively strong return-volatility relation.
In general, we believe that our paper provides an explanation for the positive
contemporaneous relation between firm-level returns and firm-level volatility documented in Duffee (1995). The sensitivity of the value of real options to underlying
volatility seems to be an important reason for the cross-sectional variation in the
relation between returns and contemporaneous changes in volatility and for the
evolution of this relation around investment and financing spikes. These findings
complement the existing literature examining the effects of real options on asset
prices (e.g., Berk, Green, and Naik (1999) and Carlson, Fisher, and Giammarino
(2004)).
While the real options hypothesis is consistent with the positive relation between volatility and stock returns at the firm level, it cannot explain the negative
correlation between these variables at the aggregate level. We argue that the negative relation between aggregate stock returns and aggregate return volatility could
be driven by an omitted variable problem. Because investors tend to be more uncertain about future real output growth during economic downturns (e.g., Veronesi
(1999)), periods of high stock return volatility could coincide with periods of low
stock returns even if the direct effect of volatility on firm value is positive. That
is, volatility may increase when stock prices decline not because the fundamental
relation between these variables is negative, but because both variables are affected

by the same underlying macroeconomic factors. Thus, regressing aggregate stock

returns on aggregate market volatility could lead to inferences that are very different from those obtained in a setting in which aggregate (market) conditions are
controlled for.
We address this issue by focusing on firm-level stock returns rather than on
aggregate returns. Using individual stock returns instead of aggregate returns allows
us to control simultaneously for aggregate factors (proxies for market conditions)
and aggregate volatility. Consistent with the aggregate evidence, regressions of firmlevel returns on aggregate volatility alone reveal a strong negative return-volatility
relation. However, once we control for aggregate market factors (aggregate market
returns, HML, and SMB), aggregate volatility becomes unrelated to stock returns.
More interestingly, we find that aggregate volatility has a positive effect on the
value of real options-based firms and a negative effect on the value of assets in
place-based firms after controlling for market conditions. These results seem to
reconcile the aggregate-level negative relation between volatility and returns with
the positive relation at the firm level.
The remainder of the paper is organized as follows. In Section I we discuss and
motivate our measure of volatility, summarize the data, and present selected summary statistics. In Section II we estimate the relation between returns and changes
in volatility for subsets of firms characterized by different mixes of real options and
assets in place. Section III investigates the effect of operating flexibility on the
volatility-return relation. Section IV examines the evolution of the relation between
returns and changes in volatility around times of significant changes in firms mix of
real options and assets in place. In Section V we perform an industry-level analysis
of the relation between returns and contemporaneous changes in volatility. In Sec-

tion VI we examine the effect of the volatility-return relation on the performance

of asset pricing models. Section VII provides evidence that aggregate volatility is
unrelated to stock returns after controlling for underlying market conditions and
examines the relation between returns and aggregate volatility for subsamples of
real options-based and assets in place-based firms. In Section VIII we discuss the
results of robustness checks. Section IX summarizes and concludes.

I. Measure of Volatility, Data Sources, and Summary

Statistics

A. Measure of Volatility
Theoretically, the value of a firms real options is increasing in the volatility of
an underlying process (e.g., McDonald and Siegel (1986)). However, many aspects
of uncertainty regarding potential projects, which include but are not limited to
demand shocks (changes in consumer tastes), supply shocks (changes in production
technologies), and institutional changes, are unobservable. Moreover, even if the
realizations of these shocks were observable ex-post, their expectations, which affect
the value of real options, would not be known. If stock prices incorporate the value
of real options, then the volatility of stock prices is expected to be related to the
volatility of the underlying valuation processes. This justifies the use of measures
stock return volatility as proxies for underlying volatility, as in Leahy and Whited
(1996) and Bulan (2005).
We follow Ang et al. (2006, 2009) and Duffee (1995), among others, and estimate
firm is volatility during month t as the standard deviation of the firms daily returns

during month t,
V OLi,t

vP
u
u (ri, ri,t )2
t t
=
,
nt 1

(1)

where ri, is the natural logarithm of day t gross excess return on firm is
stock, ri,t is the mean of the logarithms of gross daily returns on firm is stock
during month t, and nt is the number of nonmissing return observations during
month t. We use logarithmic returns to mitigate the potential mechanical effect of
return skewness (see Duffee (1995) and Kapadia (2007)) on the relation between
returns and contemporaneous return volatilities. The change in volatility in month
t, V OLi,t , is computed as the difference between the estimated volatility in month
t and the estimated volatility in month t 1:

V OLi,t = V OLi,t V OLi,t1 .

(2)

B. Main Data Sources and Summary Statistics

We obtain daily stock returns, used in estimating volatilities and factor loadings, and monthly returns, used as the dependent variable in our regressions, from
CRSP daily and monthly return files, respectively. Daily and monthly factor returns
and risk-free rates are from Ken French website (http:// mba.tuck.dartmouth.edu/
pages/faculty/ken.french/data library.html). The time frame of our analysis is from
January 1964 to December 2008. Following Ang et al. (2006), among others, we
eliminate utilities (SIC codes between 4900 and 4999) and financials (SIC codes between 6000 and 6999) from the sample. Our sample contains over 3 million monthly
observations with nonmissing returns and volatility estimates.
Accounting variables used to compute firm characteristics, measures of investment opportunities (firm size, R&D expenditures, and sales growth), measures of operating flexibility (sensitivity of firm value to profits and sales), as well as measures of
8

investment and financing spikes, are from COMPUSTAT. We obtain firms founding
and incorporation years, used to compute firm age, from Boyan Jovanovics website
(www.nyu.edu/econ/user/jovanovi). Dates of firms earnings announcements used
to estimate some of the measures of operating flexibility are from I/B/E/S. Data on
membership in labor unions are obtained from the Union Membership and Coverage database (www.unionstats.com), described by Hirsch and Macpherson (2003).1
We obtain data on seasoned equity offerings (SEOs), used in our event-time tests,
from Thomson Financials Securities Data Company. Finally, for our analysis of the
effects of real options on the return-volatility relation in the oil and gas industry,
we hand-collect data on developed and total proven oil and gas reserves for 72 oil
firms between 1995 and 2009 from firms annual reports.
We present summary statistics for returns, return volatilities, and changes in
return volatility in Table I, which also includes summary statistics for measures of
investment opportunities and managerial flexibility, which we discuss below. The Insert Tamean excess return in our sample is 0.6% per month or about 7.2% per year. The ble I here
mean (median) daily firm-level stock return standard deviation is 3.17% (2.45%).
Our firm-level volatility estimates using daily data are similar to those reported
in Ang et al. (2006). The small positive mean change in volatility (0.007%) is
consistent with the positive time trend in volatility (e.g., Campbell et al. (2001)
and Cao, Simin, and Zhao (2008)). The standard deviation of the month-to-month
change in return volatility is 1.83%.

II. Return-Volatility Relation and Investment

Opportunities

We begin by verifying that the positive relation between firm-level volatility and
9

firm-level returns documented in Duffee (1995, 2002) and Albuquerque (2012) holds
in our sample. In particular, we estimate monthly cross-sectional Fama-MacBeth
(1973) regressions of individual firm returns, ri,t , net of the risk-free rate, rf,t , on
contemporaneous changes in firm-level volatility, V OLi,t , and a vector of firm
characteristics, xi,t , most of which are known at the beginning of month t:

ri,t rf,t = t + t V OLi,t + t \

M KTi,t + t xi,t + i,t .

(3)

Following common practice in the asset pricing literature (e.g., Fama and French
(1993), Jegadeesh and Titman (1993), and Cooper, Gulen, and Schill (2008) among
many others), these characteristics are log market equity, log book-to-market, and
past returns. Following Fama and French (1993), we measure the market value of
equity as the share price at the end of June times the number of shares outstanding.
Book equity is stockholders equity minus preferred stock plus balance sheet deferred
taxes and investment tax credit if available, minus post-retirement benefit assets if
available. If stockholders equity is missing, we use common equity plus preferred
stock par value. If these variables are missing, we use book assets less liabilities.
Preferred stock is preferred stock liquidating value, preferred stock redemption value,
or preferred stock par value in that order of availability. To compute the bookto-market ratio, we use the December closing stock price times number of shares
outstanding. We match returns from January to June of year t with COMPUSTATbased variables of year t2, while the returns from July until December are matched
with COMPUSTAT variables of year t 1. Past returns are defined as buy-and-hold
returns for six months over months [t7, t2]. In addition, following Karpoff (1987),
we include contemporaneous trading volume, normalized by the number of shares
outstanding. The estimated coefficient on the market portfolio return, \
M KTi,t in

10

(3), is obtained from the following regression:

ri, rf, = i,t + M KTi,t (rm, rf, ) + i, ,

(4)

where ri, is the return of firm i in day belonging to month t, rf, is the daily
risk-free rate, and rm, is the daily return on the value-weighted market portfolio.
The results of estimating (3) are presented in Table II.2 This table shows that Insert Tacontemporaneous changes in firm-level volatility are positively related to stock re- ble II here
turns, the relation being highly statistically significant in all specifications. As
expected, the coefficients on the market factor loading and on log book-to-market
are significantly positive, while the coefficients on log size are significantly negative
in all specifications. The coefficients on contemporaneous volume are positive and
highly statistically significant, consistent with Karpoff (1987). Interestingly, while
the coefficients on past returns are positive and significant in regressions in which
trading volume is excluded, they become insignificant with the inclusion of contemporaneous trading volume. This result is consistent with Cooper, Gulen, and Schill
(2008), who find that the coefficient on past returns is sensitive to the set of other
independent variables included in return regressions.
Perhaps the most common type of real option is the option to invest (e.g.,
Brennan and Schwartz (1985), McDonald and Siegel (1986), Majd and Pindyck
(1987), and Pindyck (1988), among many others). Therefore, one way to examine
whether the relation between firms stock returns and contemporaneous changes in
return volatility is driven by the effect of volatility on the value of real options is
to compare the strength of this relation across subsamples of firms with different
mixes of investment opportunities and assets in place.
To analyze the effects of investment opportunities on the return-volatility relation, at the end of each year we sort firms based on measures of investment op11

portunities and form investment opportunity-based quintiles. We use four measures

of investment opportunities. The first (inverse) measure is firm size. Larger firms
tend to have larger proportions of their values represented by assets in place, while
smaller firms tend to rely more heavily on investment opportunities (e.g., Brown
and Kapadia (2007)). We define firm size as the book value of firm assets.
Our second (inverse) proxy for investment opportunities is firm age. Older,
more established firms tend to have larger proportions of their value represented by
existing assets (Lemmon and Zender (2010)). As in previous studies, we define a
firms age as the difference between current year and founding year, incorporation
year, or the first year in which the firms stock appears in monthly CRSP files, in
that order of availability.
The third investment opportunity proxy that we use is R&D intensity. Since
research and development generates investment opportunities, the larger the firms
relative R&D expenditures, the more real options the firm is expected to have. R&D
intensity is defined as the ratio of annual R&D expenditures and beginning-of-year
book assets.
Our fourth measure of investment opportunities is future sales growth. An increase in sales (and production) in the future is likely to be caused by the future
exercise of real options. The clear drawback of future sales growth as a measure of
current investment opportunities is that it suffers from the look-ahead bias. However, it can still be useful in our setting because the regressions we estimate are
not predictive regressions. Instead, our tests focus on the contemporaneous relation
among the variables of interest. Thus, we use realized future sales growth as an
instrument for expected sales growth. In order not to induce spurious correlation
caused by contemporaneous surprises to sales and to firm value, we measure future

12

sales growth starting from the year after the period for which the relation between
returns and changes in volatility is estimated. Specifically, future sales growth is
defined as the difference between sales four years after the year of the observation
over sales in the year following the year of the observation divided by sales in the
year following the year of the observation.
In Table III we estimate the following Fama-MacBeth cross-sectional regressions:

ri,t rf,t = t + t V OLi,t + t GRi,t V OLi,t + t \

M KTi,t + t xi,t + i,t ,

(5)

where GRi,t V OLi,t is the product of V OLi,t and one of the four investment
opportunity measures: log size, log age, log R&D to assets ratio, and future sales
growth. To allow for an intuitive interpretation of the results, we normalize each of
the investment opportunity measures by subtracting its sample mean and dividing
the resulting difference by its in-sample standard deviation. The rest of the variables
are as in (3).

Insert

In the first column, in which size is used as a proxy for the relative amount Table
of investment opportunities, the mean estimate of t , which is interpreted as the here
sensitivity of firm value to changes in volatility for a firm whose size is equal to the
sample mean, is 0.97 and is highly statistically significant. The coefficient on the
interaction between normalized log size and V OL equals -0.52, implying that a
one standard deviation reduction in log size from the sample mean is associated with
a 0.52 increase in the return-V OL relation. Returns of firms whose book assets
are two standard deviations above the sample mean are not related to changes in
volatility, while returns of firms whose assets are two standard deviations below the
mean are twice as sensitive to changes in volatility as those of firms with mean size.
To put it differently, a two standard deviations positive shock to volatility would
result, on average, in a 7.3% monthly return for small firms, while it would have no
13

III

effect on the value of large firms. The coefficient on the interaction between V OL
and log size is not only economically large, but also highly statistically significant.
The results reported in the second column, in which we use log age as an inverse
proxy for the availability of investment opportunities, are also consistent with real
options theory. The coefficient on the interaction between V OL and log age is 0.12 and is much smaller in magnitude than the corresponding coefficient in the first
column. However, this coefficient is still economically large: the relation between
V OL and returns is 48% stronger on average for a firm whose age is two standard
deviations below the sample mean than for a firm whose age is two standard deviations above the sample mean. The results using log R&D intensity, reported in the
third column, are quite similar. A one standard deviation increase in R&D expenditures from the sample mean is associated with an approximately 11% increase in
the sensitivity of firm value to volatility. Finally, the evidence based on future sales
growth, reported in the fourth column, indicates that the relation between returns
and changes in volatility is significantly stronger for firms with high future sales
growth than it is for firms with lower growth. Returns of firms with future sales
growth two standard deviations above the sample mean are 160% more sensitive to
changes in volatility on average than returns of firms whose future growth in sales
is two standard deviations below the sample mean.
Overall, the results in Table III demonstrate that value of firms with characteristics that are likely to be related to more abundant and valuable investment
opportunities are more sensitive to changes in return volatility. If return volatility
is correlated with the volatility of processes underlying firms real options, as argued in Leahy and Whited (1996) and Bulan (2005), then this evidence is consistent
with the real options-based explanation for the positive relation between returns

14

and return volatility at the firm level.

III. Return-Volatility Relation, Convexity, and

Flexibility
Real options take different forms and are not limited to investment opportunities. In this section we go beyond examining the relation between investment
opportunities and the return-volatility relation. We construct additional proxies for
the relative importance of real options for firm value and examine the return-V OL
relation across different real options subsamples.
We begin with the simple observation that if a firm has real options, then its
value function is convex in the process underlying the options. The reason is that
in real options models, managerial flexibility is what generates the convexity of the
value function with respect to the value of the underlying process (e.g., Brennan
and Schwartz (1985), McDonald and Siegel (1986), Majd and Pindyck (1987), and
Pindyck (1988)).3 Therefore, due to Jensens inequality, the sensitivity of firm value
to the volatility of its underlying assets should be increasing in the firms flexibility
to alter its operational and investment decisions (i.e., increasing in the convexity of
2

V (x)
the firms value function ( x
2 )),

E[V (x)] = E[V (x)] +

1 2 V (x) 2
x ,
2 x2

(6)

where V (x) is firm value as a function of variable x having a standard deviation of

x .
While we do not know what this underlying process is for any given firm, the
theoretical real options literature provides some guidance. In many real options
models the underlying process is either firm earnings (e.g., McDonald and Siegel
15

(1986), Pindyck (1993)) or demand for a firms product (e.g., Caballero and Pindyck
(1992)). For example, it is well established that the source of convexity of the profit
function in prices comes from the ability of firms to adjust output according to
market conditions (e.g., Marschak and Nelson (1962) and Oi (1961)). Without this
flexibility, profits would be linear in prices. Mills (1984) formalizes this argument
and shows that the expected profit of a competitive firm in a market in which prices
are stochastic equals
E((p)) = (E(p)) +

p2
,
2

(7)

where (p) denotes profit as a function of price p having variance p2 , and is

a parameter of the profit function that is inversely related to the cost of altering
output in response to price changes. Based on the intuition of Stigler (1939), is
typically referred to as a measure of flexibility. Equations (6) and (7) show that
the strength of the effect of volatility on a firms expected profit and firm value is
increasing in its flexibility.
We use two approaches to measuring flexibility. First, following the intuition in
Bernardo and Chowdhry (2002), we use the convexity of a firms value in its earnings and in its sales as proxies for operating flexibility. The economic motivation is
that if a firm is able to expand operations during good times and contract operations during bad times, then its value would be a convex function of its underlying
economic process (e.g., profits, sales). In the second approach we use the level of
union membership in the firms industry as an inverse proxy for operating flexibility.
The idea is that since the existence of unions hinders firms ability to adjust their
workforce in response to changes in economic conditions (e.g., Abraham and Medoff (1984), Gramm and Schnell (2001), and Chen, Kasperczyk, and Ortiz-Molina
(2011)), one would expect firms in highly unionized industries to be less flexible.

16

To estimate the convexity of firm value in its earnings, we focus on earnings

announcement days, obtained from I/B/E/S, and for each firm-announcement-day
observation that occurs in quarter t we estimate the following firm-level time-series
regression using data in quarters (t 20, t 1):
Abn ri, = i,t + i,t Earn surpi, + i,t Earn surpi, 2 + i, ,

(8)

where Abn ri, is the return on firm is stock on the earnings announcement day in
quarter net of its expected return on that day, which equals its beta estimated
using (4) in the month preceding the month of the earnings announcement times the
return on the market portfolio on the earnings announcement day, and Earn surpi,
is the standardized unexpected earnings (SUE).
To estimate SUE we follow the procedure in Bernard and Thomas (1989) and
Brandt et al. (2009). Specifically, we define earnings surprises as

Earn surpi, =

Earni, E(Earni, )
,
(Earni, )

(9)

where Earni, is the firms earnings per share in quarter , E(Earni, ) is quarter-
expected earnings per share, and (Earni, ) is the standard deviation of Earni,
over quarters ( 8, 1). Expected earnings per share are estimated using a
seasonal random walk model:

E(Earni, ) = Earni, 4 +

8
X

(Earni, n Earni, n4 ) /8.

(10)

n=1

The measure of convexity of firm value to its earnings surprise is the estimated
coefficient on the squared earnings surprise, c
i,t in (8). The more convex firm is
value in its earnings is, the larger c
i,t is, as investors react more strongly to good
news than to bad news, and the larger the fraction of firm value that is likely to be
attributable to real options. As in the previous section, we estimate cross-sectional
17

Fama-MacBeth regressions similar to (5), in which the interaction variables are constructed as the product of V OL and normalized convexity estimates. Column 1 of Insert
Table IV reveals that the relation between returns and contemporaneous changes in Table
volatility is increasing in the estimated convexity of firm value in its earnings. The here
coefficient on the interaction between V OL and normalized earnings convexity
is equal to 0.052. This implies that a one standard deviation increase in earnings
convexity from the sample mean is associated with an 8% increase in the magnitude of the return-V OL relation. In other words, the sensitivity of firm value
to volatility for a firm whose earnings convexity is two standard deviations above
the sample mean is 38% higher than the return-V OL relation for a firm whose
earnings convexity is two standard deviations below the sample mean.
To estimate the convexity of firm value in demand shocks, we follow the empirical
industrial organization literature (e.g., Ghosal (1991) and Guiso and Parigi (1999))
and use sales as a proxy for demand. The regression we estimate is similar to (8),
Abn ri,t = i,t + i,t Sales surpi, + i,t Sales surpi, 2 + i, ,

(11)

where Sales surpi, is estimated similar to Earn surpi, in (9). The regressions
involving sales convexity are reported in the second column of Table IV. The results
are somewhat stronger than those based on earnings convexity. The coefficient on
the interaction between V OL and sales convexity is larger than the corresponding coefficient on the interaction between V OL and earnings convexity, and it is
statistically significant. The return-V OL relation is 51% stronger for firms whose
sales convexity measure is two standard deviations above the sample mean than for
firms whose sales convexity measure is two standard deviations below the sample
mean.
As discussed above, we also use labor union membership in a firms industry as
18

IV

an inverse proxy for its operating flexibility. Chen, Kasperczyk, and Ortiz-Molina
(2011) argue that firms with a highly unionized workforce face obstacles when trying
to reduce the workforce in bad economic times. We therefore expect the returnV OL relation to be inversely related to the level of unionization. The results are
presented in the third column of Table IV. The mean coefficient on the interaction
between V OL and the normalized union membership rate equals 0.12. This
coefficient is not only statistically significant but is also economically large as it
implies that the sensitivity of value to volatility for a firm in an industry with union
membership two standard deviations above the sample mean is twice as large as the
sensitivity for a firm in an industry with union membership two standard deviations
below the sample mean. This result is consistent with the hypothesis that firms
operating in industries with higher union membership rates have lower flexibility,
resulting in a lower proportion of their value represented by real options and in a
lower sensitivity of their value to changes in volatility.
To summarize, the results in this section are consistent with the real optionsbased explanation for the positive return-V OL relation at the firm level. Firms
whose value is more convex in their earnings and sales and firms operating in industries with lower union membership are more sensitive to changes in volatility.

IV. Evolution of the Return-Volatility Relation around

Real Option Exercises

The tests in the previous two sections rely on comparing the sensitivity of firm
value to changes in return volatility across different sets of firms sorted by measures
of real options. In this section we perform an alternative test of the hypothesis that
the positive relation between firm-level returns and contemporaneous changes in
19

volatility is driven by real options. This test is based on the time-series evolution of
the return-V OL relation for firms experiencing shocks to their mix of real options
and assets in place, which occur around real options exercises.
Firms exercise many of their real options by investing. A spike in a firms real
investment rate can signal an exercise of investment options. Thus, we examine
changes in the return-V OL relation around investment spikes. If investment opportunities constitute a significant component of firm value, then this relation is
expected to be decreasing following their exercise.
We use years of abnormally high investment activity as a proxy for investment
spikes. Following Whited (2006), we define a firm-level investment spike as a year in
which the firms investment rate exceeds three times its median annual investment
rate throughout the sample period. There are 18,654 investment spike years in our
sample. For each firm-year we compute the relative timing of the previous spike
and the next spike and form five subsamples, consisting of firm-years with two years
prior to the next spike, one year prior to the spike, the spike year, one year after
the spike, and two years post investment spike.4
Panel A of Table V reports the coefficients on V OL, from regressions as in (5),
estimated for five years around investment spikes. The numbers in brackets in the
fourth column denote t-statistics from the Wald test of the equality of the V OL
coefficients in years -1 and 1 relative to an investment spike. The mean coefficient Insert Taon V OL stays roughly constant prior to the investment spike year (from year -2 ble V here
to year -1). The coefficient on V OL decreases around the investment spike (from
year -1 to the spike year, and to year 1), and then rises again (from year 1 to year
2 relative to the investment spike). The differences in the return-V OL relation
between years -1 and 1 are statistically significant and economically meaningful.

20

The sensitivity of firm value to changes in volatility is almost twice as high in the
year preceding an investment spike, during which firms are likely to exercise part of
their real options, than in the year following the investment spike year.
However, this drop could also be consistent with the following alternative explanation. There is typically a stock price run-up prior to exercises of investment
opportunities. In addition, large investments are typically followed by low returns
(e.g., Anderson and Garcia-Feijoo (2006), Lyandres, Sun, and Zhang (2008), and
Xing (2008)). In our sample, the mean returns of firms experiencing an investment
spike are 15% and 20% in years -2 and -1 relative to the spike, compared with the
mean return of 10% in the year of the spike and mean returns of -4% and 3% in
years 1 and 2 relative to the spike. Despite the fact that we use logarithmic returns
while estimating return volatilities and changes in return volatility, high returns
may be associated with high return volatilities, causing a mechanical drop in the
sensitivity of returns to changes in volatility that coincides with the drop in average
stock returns following investment spikes. To ensure that this drop in the returnV OL relation around investment spikes is not fully explained by the potentially
spurious relation between returns and return volatilities, we present evidence on the
evolution of the return-V OL relation for the sample of matched firms that did not
experience spikes in their investment activity.
Specifically, for each of the five years around an investment spike, we find a
matched firm that satisfies the following criteria. First, the matched firm has to
belong to the same quintile of beginning-of-year book assets and book-to-market as
the firm experiencing an investment spike.5 Second, to ensure that the matched firm
does not have abnormal investment intensity, we require it to have an investment
rate below its time-series median. Out of the set of firms satisfying these two criteria

21

we choose the firm with the annual stock return closest to that of the investment
spike firm. As a result, for each firm experiencing an investment spike, we find firms
with relatively low investment rates, similar characteristics, and similar returns in
each of the years around the investment spike. This procedure allows us to separate
the possible mechanical relation between returns and changes in return volatility
caused by the evolution of returns around investment spikes from the effect of the
exercise of real options on the sensitivity of firm values to changes in volatility.
The evolution of the coefficient on V OL within the matched firm sample is
also presented in Table V. The results indicate that a relatively small portion of
the reduction in the sensitivity of firm values to volatility is attributable to the
mechanical effect discussed above. The coefficient on V OL within the sample of
comparable firms decreases by less than 10% from year -1 relative to the investment
spike to year 1 relative to the spike, compared with a reduction of close to 50% for
firms going through investment spikes, the difference being statistically significant.
One potential drawback of examining the behavior of the return-V OL relation around investment spikes is the continuous nature of investments. The exercise
of an investment opportunity might not coincide with an investment spike. Thus,
we attempt to estimate the timing of the decision to exercise real options and to
transform them into assets in place. Firms frequently raise external funds in order
to finance their investments. Real options models (e.g. Carlson, Fisher, and Giammarino (2006, 2010)) regard seasoned equity offerings (SEOs) as a signal of the
decision to exercise growth options by investing the SEO proceeds. Consistent with
these models, Lyandres, Sun, and Zhang (2008) find that investment rates of firms
that issue equity are significantly higher than those of similar non-issuers. Thus,
we supplement the investment spike-based evidence by examining the evolution of

22

the return-V OL relation around SEO announcements and around spikes in new
issuance activity in general. According to real options theory, the sensitivity of firm
values to volatility is expected to decline following new issues. We construct four
subsamples of firm-years relative to the timing of firms SEOs. For example, the
first sample consists of firm-months 13 to 24 prior to an SEO event, while the fourth
sample consists of firm-months 13 to 24 after an SEO.6 There are 9,823 SEOs in our
sample. The results of estimating (5) using these event-based samples are presented
in Panel B of Table V.
The evolution of the return-V OL relation around SEO announcements is striking. Similar to the investment spike-based results, the coefficients on V OL are
increasing from event year -2 to year -1. After that, they drop by approximately
90%, from 1.87 in event year -1 to a statistically insignificant 0.21 in event year 1.
In other words, a two standard deviation shock to return volatility would lead to
an almost 7% monthly return in the last year prior to an SEO on average, while
it would lead to a 0.8% return in the first post-SEO year. The disappearance of
the positive relation between returns and changes in volatility following SEOs is
consistent with the hypothesis that SEO events coincide with exercises of real options, and with the sensitivity of the value of real options to volatility driving the
return-V OL relation. Similar to the results of investment spike based tests, the
return-V OL relation starts strengthening again from year 1 to year 2 post-SEO.
Similar to the investment spike-based tests, we want to ensure that the SEObased results are not caused by a run-up prior to SEOs and low returns following
SEOs (e.g., Loughran and Ritter (1995) and Ritter (2003)). We therefore perform a
matching procedure similar to that outlined above, while limiting the set of potential
matches to firms that have not issued seasoned equity within the previous three

23

years. The evolution of the return-V OL relation around SEOs for matched firms
has a shape similar to that of SEO firms, but the year-to-year changes in the V OL
coefficients are much smaller than within the sample of SEO firms. Specifically, the
coefficients drop from 1.32 in the last pre-SEO year to 1.17 in the first post-SEO
year. The difference between the changes in the V OL coefficients across SEO
firms and matched firms is highly statistically significant.
External financing can take various forms, seasoned equity offerings being just
one of them. Accordingly, we supplement our analysis of the evolution of the returnV OL relation around SEO events by looking at broader financing spikes, defined
as firm-years in which the combination of net new issues of equity and debt exceed
10% of beginning-of-year book assets. There are 60,128 financing spike years in
our sample. Panel C of Table V reports the results of this analysis. Similar to the
SEO-based evidence, the sensitivity of firm values to changes in volatility decreases
around years in which firms experience spikes in their overall financing activity.
The coefficient on the change in volatility drops by more than half from one year
prior to the financing spike to the first post-spike year. The differences between the
changes in the return-V OL relation around financing spikes for firms experiencing
the spikes and matched firms are large and statistically significant.
Overall, the evolution of the relation between returns and contemporaneous
changes in volatility around investment and financing spikes is consistent with the
hypothesis that the exercise of real options reduces the proportions of real options
in firm values, leading to a reduction in the sensitivity of firm values to changes in
volatility.

24

V. Industry Analysis of the Return-Volatility Relation

A. Real Option-Intensive Industries

An additional way of examining whether the positive relation between firmlevel returns and contemporaneous changes in volatility can be partially due to real
options whose values are increasing in volatility is to compare the return-V OL
relation within industries in which real options are more likely to constitute a larger
proportion of firm value to the return-V OL relation within industries in which a
larger proportion of firm value is attributable to assets in place.
Using theoretical and empirical studies as guides to identify industries with
plenty of real options, we examine the effect of volatility on returns in the following
industries:
a) Natural resources industries. Due to the nature of their products and production processes, natural resources firms are known for their ability to defer investment,
expand, contract, shut down, and restart operations according to market conditions
(e.g., Brennan and Schwartz (1985)). Consistent with this argument, Paddock,
Siegel, and Smith (1988), Moel and Tufano (2002), and Fan and Zhu (2010) empirically show that real options are important for these firms.
b) High-tech industries and pharmaceutical and biotechnology industries. Firms
in these industries are known for making staged investments, which allows them to
abandon or scale up projects at different points in time (e.g., Majd and Pindyck
(1987), Ottoo (1998), Bollen (1999), and Joos and Zhdanov (2008)).
We define Fama and French (1997) industries 27 (precious metals), 28 (mining), and 30 (oil and natural gas) as natural resources industries. We define Fama
and French industries 22 (electrical equipment), 32 (telecommunications), 35 (com-

25

puters), 36 (computer software), 37 (electronic equipment), and 38 (measuring and

control equipment) as high-tech industries.7 Finally, we define Fama and French
industries 12 (medical equipment) and 13 (pharmaceutical products) as pharmaceutical and biotechnology industries.
In Table VI we estimate cross-sectional Fama-MacBeth regressions as in (5) for
firms operating in high-tech industries, natural resources industries, and pharmaceutical and biotech industries, as defined above, and contrast the return-V OL
relations in these industries with the return-V OL relation in all other industries.
In particular, we construct natural resources/high-tech/pharmaceutical and biotech
indicator variables and augment the regression in (5) by interacting these indicator
variables with month-to-month changes in return volatility. If real options are at Insert
least partially responsible for the positive relation between returns and changes in Table
volatility, we would expect positive coefficients on each of these interaction variables. here
The results, reported in Table VI, are consistent with the real options explanation
for the positive return-V OL relation. The return-V OL relation is significantly
stronger in real option-intensive industries than in other industries: the mean coefficients on the interaction variables (0.38 for high-tech, 0.40 for natural resources,
and 0.29 for pharmaceuticals and biotech) are all statistically significant and economically sizable (they constitute 29% to 48% of the coefficient on V OL).
In the next subsection we concentrate on one industry that is likely to be characterized by relatively abundant real options oil and natural gas and examine
the return-volatility relation using an industry-specific measure of volatility of an
underlying process and an industry-specific proxy for the mix of real options and
assets in place.

B. Oil and Gas Industry

26

VI

The oil and natural gas industry serves as a convenient laboratory for examining
the effects of the mix of real options and assets in place on the sensitivity of firm
value to changes in volatility of a process underlying its real options. First, unlike
in the large-sample tests above, in which we use volatility of stock returns as a
proxy for the volatility of the process underlying real options, a more direct proxy
is available for oil and gas firms: the volatility of relative oil price changes. Second,
instead of relying on various indirect proxies for real options, we are able to construct
more direct measures of the proportion of real options in oil and gas firm values.
These measures are based on proportions of developed oil and gas reserves out of
total proven reserves. The larger the proportion of a firms remaining undeveloped
reserves, the more real options it is expected to have because undeveloped reserves
are unexercised real options. In our sample of 72 firms over the period 1995 to 2009,
the mean proportion of developed oil and gas reserves is 27%. More importantly,
there is substantial cross-sectional variation in the proportion of developed oil (gas)
reserves: the standard deviation is 21% (20%).
To examine the effect of the proportion of undeveloped reserves on the returnV OL relation we estimate the following regression:

ri,t rf,t = +OILV OLt +P ROPi,t OILV OLt +OILRETt + \

M KTi,t + xi,t +i,t ,
(12)
where OILV OLt is the month-to-month change in oil return volatility and
P ROPi,t OILV OLt is an interaction variable equal to the product of the proportion of undeveloped reserves, P ROPi,t , and the month-to-month change in the
volatility of daily relative oil price changes, OILV OLt . The variable P ROPi,t
takes one of three values: the proportion of undeveloped oil reserves, the proportion
of undeveloped gas reserves, and the weighted average of these two proportions, prox-

27

ying for the overall proportion of undeveloped reserves.8 We compute OILV OLt as
the standard deviation of the daily percentage changes in the price of Brent Crude
oil during month t and OILRETt as the monthly relative change in oil price (i.e.,
oil return). All other variables are defined as in (3). We estimate (12) as a panel
and, following Petersen (2009), cluster standard errors by month. The estimates of
(12) are presented in Panel A of Table VII.

Insert Ta-

Not surprisingly, an increase (decrease) in oil price is associated with an increase ble
(reduction) in oil firm value. Similar to the evidence in Tables II-IV, firm value is here
positively related to contemporaneous changes in oil return volatility. Importantly,
the coefficients on the interactions between the change in oil return volatility and
all three measures of undeveloped reserves are positive and highly significant. An
increase (decrease) in oil price volatility has a larger positive (negative) impact
on the value of firms that have unexercised options to develop a larger proportion
of their proven reserves. For example, a one standard deviation increase in the
proportion of undeveloped reserves is associated with a 0.4 to 0.5 increase in the
coefficient on oil return volatility. Stated differently, the relation between oil firms
returns and changes in oil return volatility is 224% to 375% stronger for firms with a
proportion of undeveloped reserves that is two standard deviations above the sample
mean than for firms with no undeveloped reserves. This result is consistent with the
broad calendar-time and event-time evidence in the previous sections: a firms mix
of real options and assets in place affects the sensitivity of firm value to changes in
the volatility of its underlying assets.

VI. Real Options and Asset Pricing Tests

In this section we present results of a test of the real options explanation for

28

VII

the positive relation between returns and changes in volatility that is based on the
performance of asset pricing models for real options-based firms and assets in placebased ones. Da, Guo, and Jagannathan (2012) argue that real options may be one
of the reasons for the poor performance of the CAPM in explaining the cross section
of returns. The idea is that since firms consist of multiple investment options that
may be exercised at different times, the CAPM (or more generally, any asset pricing
model that does not account for real options) may be unsuccessful in explaining
firms stock returns even if it explains returns to individual projects perfectly (e.g.,
McDonald and Siegel (1985) and Berk, Green, and Naik (1999)). This logic implies
that the success of an asset pricing model should be related to the proportion of
real options in the value of firms whose returns are used in testing the model. In
this section we examine the ability of the CAPM and the Fama and French (1993)
three-factor model to explain returns of firms with different mixes of real options
and assets in place.
All of the results in the previous four sections show that the sensitivity of returns
to changes in volatility is positively associated with various measures of real options.
This implies that sorting firms by the sensitivity of their returns to changes in
volatility would result in groups of firms with varying mixes of real options and
assets in place. It would then be possible to compare the performance of asset
pricing models across real option-based subsamples of firms.
To estimate the sensitivity of firm value to volatility, for each firm i in month t
we estimate the following firm-level time-series regression using data during months
(t 60, t 1):
ri, rf, = i,t + i,t (rm, rf, ) + i,t V OLi, + i, .

(13)

The estimated coefficient on V OLi, , c

i,t , is the sensitivity of firm is value to the
29

change in volatility assigned to firm i in month t. Each month we sort firms by

c
i,t and assign them into real options quintiles. The highest quintile contains
firms with the largest proportion of their value represented by real options, while
the lowest quintile contains assets in place-based firms. Then, within each real
options quintile each month we sort firms by their estimated market beta, c
i,t , and
assign them into five beta quintiles.
We compute monthly value-weighted returns of the resulting 25 portfolios and
estimate time-series regressions of portfolio excess returns on the excess returns of
the market portfolio:
rp,t rf,t = p + p (rm,t rf,t ) + p,t ,

(14)

where rp,t is the monthly return of each of the 25 portfolios. Panel A of Table VIII
presents the estimated intercepts of (14) for each of the twenty five portfolios as well
as the loadings on the excess market return. In addition, within each real options
group, we compute the average pricing error (i.e., the mean absolute value of the
intercepts of (14)) and the Gibbons, Ross, and Shanken (1989) statistic (GRS) for
testing whether the pricing errors of the five beta portfolios within each real options
quintile are jointly zero. The mean pricing error for the lowest real options group Insert Tais 14 basis points per month, substantially lower than the mean pricing error for ble
the highest real options group, which equals 25 basis points per month. The GRS here
F-statistic is a statistically insignificant 1.32 (p-value of 0.25) for the lowest real
options quintile, while it is a highly significant 5.4 (p-value of less than 0.001) for
the highest-real-options quintile. With the exception of the second quintile, the
GRS statistic is monotonically increasing as we move from portfolios of firms with
more assets in place to portfolios of firms with more real options.
The evidence in Panel A of Table VIII shows that while the CAPM is comfort30

VIII

ably rejected when the testing portfolios include firms with abundant real options, it
performs much better when portfolios of assets in place-based firms are being used.
This is consistent with the argument in Da, Guo, and Jagannathan (2012) and with
the models of McDonald and Siegel (1985) and Berk, Green, and Naik (1999).
In Panel B of Table VIII we perform similar tests of the Fama and French (1993)
three-factor model. Specifically, we estimate time-series regressions of the form

rp,t rf,t = p + 1,p (rm,t rf,t ) + 2,p HM Lt + 3,p SM Bt + i,t

(15)

for the 25 portfolios discussed above. The results are quite similar to the CAPMbased evidence. There is a large difference between the average pricing error within
the lowest real options-based group and that within the highest real options group,
0.08 and 0.21, respectively. In addition, the three-factor model can be comfortably
rejected for real-option-intensive firms (F-statistic=4.07, p-value=0.001), while it
cannot be rejected for assets in place-based firms (F-statistic=0.58, p-value=0.72).
Overall, the evidence in this section suggests that nonlinearities of firm value
with respect to the value of firms projects/investments could contribute to failures
of asset pricing models in explaining returns of certain portfolios. The evidence also
suggests that samples of firms with relatively low sensitivity of value to volatility
(i.e., firms with relatively few real options) may be better suited for testing asset
pricing models, consistent with the return-volatility relation being correlated with
the mix of real options and assets in place.

VII. Aggregate Returns and Aggregate Volatility

As mentioned in the introduction, numerous studies (e.g., French, Schwert, and
Stambaugh (1987), and Duffee (1995)) find a negative contemporaneous relation

31

between aggregate market excess return and aggregate market volatility, in contrast
to the positive relation at the firm level. In this section we examine the potential
reason for the discrepancy between the firm-level and aggregate evidence.
We begin our analysis by replicating the existing evidence on the relation between aggregate volatility and stock returns. The first column in Panel A of Table
IX presents estimates of the regression of market excess return on contemporaneous
market volatility:
rm,t rf,t = + V OLm,t + t ,

(16)

where rm,t is the return on the value-weighted market portfolio in month t, rf,t
is the risk-free rate in month t, and V OLm,t is the standard deviation of daily
returns on the value-weighted market portfolio during month t, estimated as in
(1). Similar to the evidence in past studies, the relation between market excess Insert
return and contemporaneous aggregate volatility is negative and highly statistically Table
significant.

here

In the second column of Panel A we estimate a regression similar to (16), but

instead of return volatilities we use changes in volatility, defined in (2):

rm,t rf,t = + V OLm,t + t .

(17)

As in the case of the levels of aggregate volatility, market returns are negatively and
significantly related to contemporaneous changes in aggregate volatility.
As mentioned in the introduction, various hypotheses, such as the leverage effect
and increased risk premia caused by increased volatility, have been proposed as
explanations for the negative relation between market returns and (changes in)
aggregate volatility. One additional reason for the negative relation between returns
and return volatility at the aggregate level is a variable potentially omitted from (16)

32

IX

and (17) that could affect both (levels of and changes in) aggregate volatility and
returns on the market portfolio. For instance, an improvement (deterioration) in
aggregate market conditions could have both a positive (negative) impact on market
return and a negative (positive) effect on aggregate volatility. In other words, the
negative relation between aggregate market returns and aggregate volatility could
potentially be spurious and driven by an omitted proxy for contemporaneous changes
in macroeconomic conditions.
To examine whether the omitted variable problem may be responsible for the
negative relation between aggregate returns and return volatility, in Panel B of Table
IX we estimate the relation between individual stock returns and contemporaneous
changes in aggregate volatility, while controlling for the returns on the Fama and
French (1993) three factors:
ri,t rf,t = i + i V OLm,t + 1,i (rm,t rf,t ) + 2,i SM Bt + 3,i HM Lt + i,t . (18)
Using individual stock returns instead of aggregate market returns as the dependent
variable allows us to simultaneously control for market factors as well as aggregate
volatility. We use a panel data approach to estimate the parameters of (18) and,
following Petersen (2009), cluster standard errors by month.
As evident from the first column in Panel B, in which aggregate factor returns are
excluded from (18), the coefficient on the change in aggregate volatility is negative
and highly significant, similar to the aggregate evidence in Panel A. Augmenting the
regressions by the contemporaneous return on the market portfolio, in the second
column, reduces the magnitude of the coefficient on the change in market volatility
by about two-thirds, but it remains negative and significant. Further augmenting
the regressions by returns on the SMB and HML factor mimicking portfolios, in
the third column, results in zero relation between returns and changes in aggregate
33

volatility.
Finally, in Panel C we investigate the relation between firm-level returns and
aggregate volatility changes by examining the coefficient on the change on aggregate volatility across different portfolios based on proxies for growth options and
proxies for operating flexibility. To conserve space we only report the coefficients on
V OLm,t . Consistent with the theory, we find that aggregate volatility has a positive effect on the value of real options-based firms and a negative effect on the value
of assets in place-based firms. Specifically, we find that small firms, young firms,
high R&D firms, high growth firms, and more flexible firms have a strong positive
aggregate volatility-return relation while large firms, old firms, low R&D firms, low
growth firms, and less flexible firms tend to have a much weaker and sometimes
negative relation between returns and changes in aggregate volatility. This result
is important, as it demonstrates that the negative relation between aggregate market returns and contemporaneous volatility is not necessarily inconsistent with the
positive relation at the firm level. Further, it shows that real options are important
even at the aggregate level.

VIII. Robustness Checks

In this section we examine the robustness of our results. First, we examine

whether month-to-month changes in daily return volatilities are driven by transitory
jumps in stock prices as opposed to permanent changes in the diffusion component
of stock price evolution. We then proceed to examine possible nonlinearities in the
relation between firm value and changes in volatility and the potential joint effects
of shocks to volatility and shocks to liquidity on returns. Next, we examine whether
the leverage hypothesis or the resale option hypothesis can potentially explain

34

some of the results. Finally, we examine the robustness of our results involving oil
and gas firms to controlling for expected changes in oil return volatility. In this
section, to save space, we do not tabulate the results but instead discuss the main
findings. The results that we discuss below are available in the Internet Appendix.9
A. Are Changes in Return Volatility Driven by Jumps in Daily Stock Prices?
Throughout the paper we use the volatility of daily stock returns as a proxy
for the volatility of the process underlying firm value. However, an alternative
interpretation of month-to-month changes in daily stock return volatility is that
they mainly reflect transitory jumps in daily stock prices. If high return volatility in
a given month is driven by large daily returns that occurred during that month, then
we could observe a positive relation between monthly returns and return volatility.
In this subsection we discuss a battery of tests designed to distinguish between
the two interpretations discussed above. We begin by computing the correlations
among return volatility, V OLi,t , month-to-month change in volatility, V OLi,t ,
maximum daily return within a month, M AXi,t , and minimum daily return within
the month, M INi,t . If the positive return-volatility relation is driven by positive
daily price jumps, we should expect to find a higher (absolute) correlation between
V OLi,t and M AXi,t than between V OLi,t and M INi,t . However, the former
correlation is 0.338, while the latter one is -0.354, inconsistent with the hypothesis
that the positive return-V OL relation is driven primarily by positive daily price
jumps.
Second, if changes in return volatility are driven entirely by transitory price
jumps, we would expect changes in volatility to reverse completely. To examine
whether this is the case, we analyze the evolution of volatility before and after large
volatility shocks. Specifically, we track volatility for 12 months before and after firm35

months in which the change in volatility is in the top or bottom 10% of the sample.
Close to half of positive and negative changes in volatility seem to be permanent,
in the sense that they are not reversed within 12 months.
Third, to ensure that our results are not driven by positive price jumps, we
estimate the return-V OL relation while omitting potential jumps from the sample.
Specifically, we replicate the cross-sectional tests in Tables III and IV while excluding
the top 5% and bottom 5% of daily returns, and obtain results similar to those in
the body of the paper. The Internet Appendix reports the results obtained using
the middle 90% of return observations.
Fourth, Frazzini and Lamont (2007) show that returns around earnings announcements are typically positive, and trading volume around earnings announcements is abnormally high. If abnormal volume is associated with abnormal return
volatility, then the positive return-V OL relation may be driven by the effect of
earnings announcements. To ensure that this is not the case, we repeat the crosssectional tests while excluding earnings announcement firm-months and obtain results consistent with those in Tables III and IV.
Fifth, we remove the potential mechanical relation between returns and return
volatility by computing them on different days. Specifically, we compute monthly
returns while using returns on even days, and compute return volatility using returns
on odd days. If the return-V OL relation is driven by jumps in daily stock prices,
we should not see any relation between returns and return volatility when they
are computed on different days. However, the cross-sectional results stay intact,
suggesting that they are not driven by daily stock price jumps.
Finally, we repeat the tests while extracting the diffusion component of stock
return volatility. In particular, we follow the methodology proposed by Barndorff-

36

Nielsen and Shephard (2004, 2006) and Andersen, Bollerslev, and Diebold (2007)
to separate the continuous sample path variation from the discontinuous jump part
of the variation using the realized bipower variation measure. We then repeat the
cross-sectional tests while using the estimates of the diffusion component of the price
process instead of raw price changes and obtain results similar to those reported in
the body of the paper.
Overall, the tests discussed in this subsection suggest that the relation between
proxies for the mix of real options and assets in place and the sensitivity of returns
to changes in volatility are not driven by positive daily price jumps.

B. Nonlinearities in the Return-V OL Relation

To verify that potential nonlinearities in the return-V OL relation do not drive

our results, we estimate regressions in which instead of interacting V OL with
measures of real options directly, we use a four-by-one vector of interaction variables,
defined as the product of the contemporaneous change in return volatility and a
dummy variable equal to one if the firm belongs to the second (third, fourth, fifth)
real options quintile, and equal to zero otherwise. The results indicate that in the
majority of specifications the return-V OL relation is monotonically increasing as
we move from the lowest real options quintile to the highest real options quintile.

C. The Joint Effects of Volatility and Liquidity

Bandi, Moise, and Russell (2008) show that shocks to market liquidity and
shocks to market volatility jointly affect market returns. To investigate the joint
effects of changes in firm-level volatility and firm-level liquidity on returns, we augment the regressions in (5) by including month-to-month changes in Amihuds (2002)
illiquidity measure. Including this measure in the set of explanatory variables does
37

not change the coefficients on the change in volatility substantially. The coefficients on illiquidity innovation are negative in all specifications, consistent with
increases (decreases) in illiquidity leading to contemporaneous drops (increases) in
stock prices.

D. Leverage Hypothesis

A potential concern is that there could be sizeable differences in asset volatility

across the various subsamples in split-sample tests. We address this concern as
follows. We first split the sample each month into deciles of leverage. We then
split each of the 10 subsamples into quintiles of volatility levels. Comparing the
return-volatility relation across leverage subsamples while controlling for volatility
reveals that generally there is no particular pattern in the relation between leverage
and the sensitivity of returns to volatility.

E. Resale Option Hypothesis

Scheinkman and Xiong (2003) develop a theoretical model in which overconfidence generates divergence of opinion among investors about the true value of an
asset. They show that, in the presence of short-selling constraints, these heterogeneous beliefs create a situation in which a buyer of an asset receives an implicit
option to resell the asset at a higher price to a more overconfident investor. Because the value of this resale option is increasing in the volatility of the fundamental
process, the price bubble generated by the resale option is positively correlated
with volatility. Therefore, the resale option hypothesis provides an alternative explanation for the positive relation between changes in volatility and stock returns
documented by Duffee (1995).
Although Battalio and Schultz (2006), Schultz (2008), and Griffin et al. (2011)
38

do not find evidence supporting some of the main predictions of the resale option
hypothesis, in this subsection we examine whether this hypothesis can explain the
positive volatility-return relation at the firm level. As demonstrated by Scheinkman
and Xiong (2003), the sensitivity of the price bubble to changes in the volatility
of the underlying asset increases as the level of overconfidence increases. Thus, if
the resale option hypothesis is partially responsible for our results, then the positive relation between changes in volatility and stock returns should be stronger in
times when investors confidence is relatively high. To test this prediction, we use
Baker and Wurglers (2006) measure of investor sentiment to proxy for the level of
overconfidence in the market. This proxy seems to be a natural measure to test the
resale option hypothesis because it tends to be high during episodes that have been
classified as irrational bubbles and it has been shown to capture overvaluation in
the cross-section of stock returns (see Baker and Wurgler (2006)).
To examine the effect of overconfidence on the volatility-return relation, we augment the regression in (5) by including an additional term in which we interact
the measure of investor sentiment with the change in volatility. Contrary to the
predictions of the resale option hypothesis, we do not find any evidence that the
sensitivity of stock prices to changes in volatility increases during periods of high
investor sentiment. This evidence points out to an alternative interpretation of the
investor sentiment measure it could be that investors are optimistic and enthusiastic in those years, not because of any irrational exuberance, but because the
economy is doing well. Therefore, because firms are more likely to exercise their
real options during good economic times, the sensitivity of stock prices to changes
in volatility declines during those periods. Overall, our results do not support the
idea that the resale option drives the observed positive correlation between stock

39

returns and changes in volatility.

F. Controlling for Expected Changes in Volatility of Oil Returns

Carlson, Khokher, and Titman (2007) show theoretically and empirically that
future volatility of oil returns is higher when the forward curve is steeply upward
sloping (in contango) or downward sloping (backwardated). Thus, it could be argued
that changes in oil return volatility used in the tests in Section V.B may be partially
predictable. To address this concern, we follow Carlson, Khokher, and Titman
(2007) and estimate the unexpected component of changes in oil return volatility.
Specifically, we first de-seasonalize oil return volatility by regressing it on 12 monthly
dummy variables. We then regress de-seasonalized oil return volatility on the deseasonalized slope of the term structure of oil futures, obtained from Tick data, and
its square.10 We next compute month-to-month unexpected changes in oil return
volatility as the month-to-month differences in the residuals of this regression. Using
the unexpected component of the change in oil return volatility instead of the raw
change in oil return volatility does not affect the qualitative results.

IX. Conclusions
In this paper we provide evidence suggesting that an important reason for the
positive contemporaneous relation between firm-level returns and firm-level volatility, first documented by Duffee (1995), is the presence of real options. Consistent
with the theoretical argument that the value of a real option is increasing in the
volatility of the underlying process, we find that firms with more real options exhibit
a stronger sensitivity of firm value to underlying volatility.
Using various proxies for the proportion of firm value represented by investment

40

opportunities, we show that the value of firms with abundant investment opportunities is highly sensitive to changes in volatility, while firms that derive most of
their values from existing assets exhibit substantially lower sensitivities of values to
volatility. In addition, we find that the cross-sectional relation between volatility and
returns is stronger for firms that have more operating flexibility and more convex
value functions. We also find that firms with plenty of growth and strategic options
(high-tech firms, pharmaceuticals, and biotechnological firms) and with high levels
of operating flexibility (natural resources firms) tend to exhibit a stronger volatilityreturn relation. In addition, we focus on the oil and gas industry, for which we are
able to construct industry-specific measures of the mix of real options and assets
in place and of the volatility of the underlying process (oil price). We find results
consistent with the large-sample evidence.
Time-series results further reinforce the real options hypothesis. Using periods of abnormally high investment activity and abnormally high financing activity,
and in particular SEOs, as proxies for real option exercise times, we find a highly
economically and statistically significant decline in the sensitivity of firm values to
volatility around times of real option exercises, consistent with the hypothesis that
a reduction in the amount of remaining real options reduces the sensitivity of firm
value to underlying volatility.
We also build on recent findings on the effects of real options on the performance of asset pricing models. Da, Guo, and Jagannathan (2012) show that in
the presence of real options, the CAPM cannot explain equity returns because equity expected returns become nonlinear functions of the expected returns of the
underlying projects. Thus, if the positive correlation between volatility and returns
is mainly driven by real option effects, then one would expect the performance of

41

the CAPM (or any other asset pricing model) to be stronger within subsamples of
firms with a relatively weak return-volatility relation (i.e., firms with relatively few
real options). Consistent with this logic, we find that the CAPM and Fama and
French (1993) three-factor model perform better within subsamples of firms with a
relatively weak relation between returns and changes in volatility than within subsamples of firms with a relatively strong return-volatility relation. This provides
another piece of evidence linking the positive return-volatility relation at the firm
level to real options.
Finally, our paper suggests a rational explanation for the discrepancy between
the negative volatility-return relation at the aggregate level and the positive relation
at the firm level. We argue that the negative relation between aggregate returns and
aggregate volatility could be driven by common underlying economic factors affecting both variables. Consistent with this argument, we show that after controlling
for aggregate market conditions, aggregate volatility has no relation with individual stock returns. Moreover, the relation between firm-level returns and aggregate
volatility tends to be significantly positive for real options-based firms, while it is
much weaker and sometimes negative for assets in place-based firms.
In general, our findings support the real options-based explanation for the positive relation between volatility and returns. This result sheds light on the fundamental issue of how volatility affects asset prices.

42

REFERENCES
Abraham, Katharine, and James Medoff, 1984, Length of service and layoffs in
union and nonunion work groups, Industrial and Labor Relations Review 38,
87-97.
Albuquerque, Rui, 2012, Skewness in stock returns: Reconciling the evidence on
firm versus aggregate returns, Review of Financial Studies, forthcoming.
Amihud, Yakov, 2002, Illiquidity and stock returns: Cross-section and time-series
effects, Journal of Financial Markets 5, 31-56.
Andersen, Torben, Tim Bollerslev, and Francis Diebold, 2007, Roughing it up:
Including jump components in measuring, modelling and forecasting asset
return volatility, Review of Economics and Statistics 89, 701-120.
Anderson, Christopher, and Luis Garcia-Feijoo, 2006, Empirical evidence on capital
investment, growth options, and security prices, Journal of Finance 61, 171194.
Ang, Andrew, Robert Hodrick, Yuhang Xing, and Xiaoyan Zhang, 2006, The crosssection of volatility and expected returns, Journal of Finance 61, 259-299.
Ang, Andrew, Robert Hodrick, Yuhang Xing, and Xiaoyan Zhang, 2009, High idiosyncratic volatility and low returns: International and further U.S. evidence,
Journal of Financial Economics 91, 1-23.
Baker, Malcolm, and Jeffrey Wurgler, 2006, Investor sentiment and the crosssection of stock returns, Journal of Finance 61, 1645-1680.
Bandi, Federico, Claudia Moise, and Jeffrey Russell, 2008, The joint pricing of
volatility and liquidity, working paper, University of Chicago.
43

Barber, Brad, and John Lyon, 1997, Detecting long-run abnormal stock returns:
The empirical power and specification of test statistics, Journal of Financial
Economics 43, 341-372.
Barndorff-Nielsen, Ole, and Neil Shephard, 2004, Power and bipower variation with
stochastic volatility and jumps, Journal of Financial Econometrics 2, 1-37.
Barndorff-Nielsen, Ole, and Neil Shephard, 2006, Econometrics of testing for jumps
in financial economics using bipower variation, Journal of Financial Econometrics 4, 1-30.
Battalio, Robert, and Paul Schultz, 2006, Options and the bubble, Journal of
Finance 61, 2071-2102.
Berk, Jonathan, Richard Green, and Vasant Naik, 1999, Optimal investment,
growth options, and security returns, Journal of Finance 54, 1553-1607.
Bernard, Victor, and Jacob Thomas, 1989, Post-earnings announcement drift: Delayed price response or risk premium, Journal of Accounting Research 27, 1-35.
Bernardo, Antonio, and Bhagwan Chowdhry, 2002, Resources, real options, and
corporate strategy, Journal of Financial Economics 63, 211-234.
Black, Fischer, 1976, Studies of stock price volatility changes, In proceedings of the
Business and Economic Statistics Section, American Statistics Association.
Bollen, Nicolas, 1999, Real options and product life cycles, Management Science
45, 670-684.
Brandt, Michael, Runeet Kishore, Pedro Santa-Clara, and Mohan Venkatachalam,
2009, Earnings announcements are full of surprises, working paper, Duke University.
44

Brennan, Michael, and Eduardo Schwartz, 1985, Evaluating natural resource investments, Journal of Business 58, 135-157.
Brown, Gregory, and Nishad Kapadia, 2007, Firm-specific risk and equity market
development, Journal of Financial Economics 84, 358-388.
Bulan, Laarni, 2005, Real options, irreversible investment and firm uncertainty:
New evidence from U.S. firms, Review of Financial Economics 14, 255-279.
Caballero, Ricardo, and Robert Pindyck, 1992, Uncertainty, investment, and industry evolution, working paper, MIT.
Campbell, John, and Ludger Hentschel, 1992, No news is good news: An asymmetric model of changing volatility in stock returns, Journal of Financial Economics 31, 281-318.
Campbell, John, Martin Lettau, Burton Malkiel, and Yexiao Xu, 2001, Have individual stocks become more volatile? An empirical exploration of idiosyncratic
risk, Journal of Finance 56, 1-44.
Cao, Charles, Timothy Simin, and Jing Zhao, 2008, Can growth options explain
the trend in idiosyncratic risk? Review of Financial Studies 21, 2599-2633.
Carlson, Murray, Adlai Fisher, and Ron Giammarino, 2004, Corporate investment
and asset price dynamics: Implications for the cross-section of returns, Journal
of Finance 59, 2577-2603.
Carlson, Murray, Adlai Fisher, and Ron Giammarino, 2006, Corporate investment
and asset price dynamics: Implications for SEO event studies and long-run
performance, Journal of Finance 61, 1009-1034.

45

Carlson, Murray, Adlai Fisher, and Ron Giammarino, 2010, SEO risk dynamics,
Review of Financial Studies 23, 4026-4077.
Carlson, Murray, Zeigham Khokher, and Sheridan Titman, 2007, Equilibrium exhaustible resource price dynamics, Journal of Finance 62, 1663-1703.
Chemmanur, Thomas, Shan He, and Debarshi Nandy, 2010, The going public
decision and the product market, Review of Financial Studies 23, 1855-1908.
Chen, Jason, Marcin Kasperczyk, and Hernan Ortiz-Molina, 2011, Labor unions,
operating flexibility, and the cost of equity, Journal of Financial and Quantitative Analysis 46, 25-58.
Christie, Andrew, 1982, The stochastic behavior of common stock variances: Value,
leverage and interest rate effects, Journal of Financial Economics 10, 407-432.
Cooper, Michael, Huseyin Gulen, and Michael Schill, 2008, Asset growth and the
cross-section of stock returns, Journal of Finance 63, 1609-1652.
Da, Zhi, Re Guo, and Ravi Jagannathan, 2012, CAPM for estimating the cost
of equity capital: Interpreting the empirical evidence, Journal of Financial
Economics 103, 204-220.
Duffee, Gregory, 1995; Stock return and volatility. A firm-level analysis, Journal
of Financial Economics 37, 399-420.
Duffee, Gregory, 2002, Balance sheet explanations for asymmetric volatility, working paper, University of California.
Fama, Eugene, and Kenneth French, 1993, Common risk factors in the returns of
stocks and bonds, Journal of Financial Economics 33, 3-56.

46

Fama, Eugene, and Kenneth French, 1997, Industry costs of equity, Journal of
Financial Economics 49, 153-193.
Fama, Eugene, and James MacBeth, 1973, Risk, return, and equilibrium: Empirical
tests, Journal of Political Economy 81, 607-636.
Fan, Ying, and Lei Zhu, 2010, A real options-based model and its application to
Chinas overseas oil investment decisions, Energy Economics 32, 627-637.
Frazzini, Andrea, and Owen Lamont, 2007, The earnings announcement premium
and trading volume, working paper, University of Chicago.
French, Kenneth, William Schwert, and Robert Stambaugh, 1987, Expected stock
returns and volatility, Journal of Financial Economics 19, 3-29.
Galai, Dan, and Ronald Masulis, 1976, The option pricing model and the risk
factor of stock, Journal of Financial Economics 3, 53-81.
Ghosal, Vivek, 1991, Demand uncertainty and the capital-labor ratio: Evidence
from the U.S. manufacturing sector, Review of Economics and Statistics 73,
157-161.
Gibbons, Michael, Stephen Ross, and Jay Shanken, 1989, The test of the efficiency
of a given portfolio, Econometrica 57, 1121-1152.
Gramm, Cynthia, and John Schnell, 2001, The use of flexible staffing arrangements
in core production jobs, Industrial and Labor Relations Review 54, 245-268.
Griffin, John, Jeffrey Harris, Tao Shu, and Selim Topaloglu, 2011, Who drove and
burst the tech bubble? Journal of Finance 66, 1251-1290.
Guiso, Luigi, and Giuseppe Parigi, 1999, Investment and demand uncertainty,
Quarterly Journal of Economics 114, 185-227.
47

Hirsh, Barry, and David Macpherson, 2003, Union membership and coverage database
from the current population survey: Note, Industrial and Labor Relations Review 56, 349-354.
Jegadeesh, Narasimhan, and Sheridan Titman, 1993, Returns to buying winners
and selling losers: Implications for stock market efficiency, Journal of Finance
48, 65-91.
Joos, Philip, and Alexei Zhdanov, 2008, Earnings and equity valuation in the
biotech industry: Theory and evidence, Financial Management 37, 431-459.
Kapadia, Nishad, 2007, The next Microsoft? Skewness, idiosyncratic volatility, and
expected returns, working paper, Rice University.
Karpoff, Jonathan, 1987, The relation between price changes and trading volume:
A survey, Journal of Financial and Quantitative Analysis 22, 109-126.
Leahy, John, and Toni Whited, 1996, The effect of uncertainty on investment: some
stylized facts, Journal of Money, Credit, and Banking 28, 64-83.
Lemmon, Michael, and Jaime Zender, 2010, Debt capacity and tests of capital
structure theories, Journal of Financial and Quantitative Analysis 45, 11611187.
Loughran, Tim, and Jay Ritter, 1995, The new issues puzzle, Journal of Finance
50, 23-51.
Lyandres, Evgeny, Le Sun, and Lu Zhang, 2008, The new issues puzzle: Testing
the investment-based explanation, Review of Financial Studies 21, 2825-2855.
Lyon, John, Brad Barber, and Chih-Ling Tsai, 1999, Improved methods for tests
of long-run abnormal stock returns, Journal of Finance 54, 165-201.
48

Majd, Saman, and Robert Pindyck, 1987, Time to build, option value, and investment decisions, Journal of Financial Economics 18, 7-27.
Marschak, Thomas, and Richard Nelson, 1962, Flexibility, uncertainty, and economic theory, International Review of Economics 14, 42-58.
McDonald, Robert, and Daniel Siegel, 1985, Investment and valuation of firms
when there is an option to shut down, International Economic Review 26,
331-349.
McDonald, Robert, and Daniel Siegel, 1986, The value of waiting to invest, Quarterly Journal of Economics 101, 707-727.
Mills, David, 1984, Demand fluctuations and endogenous firm flexibility, Journal
of Industrial Economics 33, 55-71.
Moel, Alberto, and Peter Tufano, 2002, When are real options exercised? An
empirical study of mine closings, Review of Financial Studies 15, 35-64.
Newey, Whitney, and Kenneth West, 1987, A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix, Econometrica 55, 703-708.
Oi, Walter, 1961, The desirability of price instability under perfect competition,
Econometrica 29, 58-64.
Ottoo, Richard, 1998, Valuation of internal growth opportunities: The case of
a biotechnology company, Quarterly Review of Economics and Finance 38,
615-633.
Paddock, James, Daniel Siegel, and James Smith, 1988, Option valuation of claims
on real assets: The case of offshore petroleum leases, Quarterly Journal of
49

Economics 103, 479-508.

Petersen, Mitchell, 2009, Estimating standard errors in finance panel data sets:
Comparing approaches, Review of Financial Studies 22, 435-480.
Pindyck, Robert, 1988, Irreversible investment, capacity choice, and the value of
the firm, American Economic Review 78, 969-985.
Pindyck, Robert, 1993, A note on competitive investment under uncertainty, American Economic Review 83, 273-277.
Ritter, Jay, 2003, Investment banking and security issuance, in George Constantinides, Milton Harris, and Rene Stulz, eds.: Handbook of Economics and
Finance (North Holland, Amsterdam).
Scheinkman, Jose, and Wei Xiong, 2003, Overconfidence and speculative bubbles,
Journal of Political Economy 111, 1183-1219.
Schultz, Paul, 2008, Downward-sloping demand curves, the supply of shares, and
the collapse of internet stock prices, Journal of Finance 63, 351-378.
Stigler, George, 1939, Production and distribution in the short run, Journal of
Political Economy 47, 305-327.
Veronesi, Pietro, 1999, Stock market overreactions to bad news in good times:
A rational expectations equilibrium model, Review of Financial Studies 12,
975-1007.
Whited, Toni, 2006, External finance constraints and the intertemporal pattern of
intermittent investment, Journal of Financial Economics 81, 467-502.
Xing, Yuhang, 2008, Interpreting the value effect through the Q-theory: An empirical investigation, Review of Financial Studies 21, 1767-1795.
50

Notes

1 These

data use the Census Industry Classification (CIC) to classify industries,

which we map into Standard Industry Classification (SIC) codes and North American Industry Classification System (NAICS) in order to match them with Compustat
and CRSP.
2 Here

and below, the standard errors of the Fama-MacBeth (1973) estimates are

computed using Newey-West (1987) heteroskedasticity and autocorrelation consistent variance-covariance matrices.
3 The

presence of leverage can also generate convexity in the value function (e.g.,

Galai and Masulis (1976)). However, we show below that our results are not driven
by the leverage effect.
4 We

exclude firm-years for which we cannot unambiguously assign the timing

relative to a spike. This occurs for firm-years with fewer than three years since the
last spike and fewer than three years until the next spike.
5 We

match firms based on their size and book-to-market ratio following Barber

and Lyon (1997) and Lyon, Barber, and Tsai (1999).

6 Similar

to investment spikes, when examining the return-V OL relation around

SEOs, we exclude firm-months within two years of at least two SEO events.
7 This

classification is broadly consistent with the definition used in Chemmanur,

He, and Nandy (2010), who define high-tech industries based on three-digit SIC
codes.
8 We

convert cubic feet of natural gas to barrels of oil equivalent by multiplying

51

the former by 0.0001767.

9 The

10 As

Internet Appendix is available on the Journal of Finance website at http://www.afajof.org/Supplem

in Carlson, Khokher, and Titman (2007), the slope of the term structure of

oil futures is computed using the nearest and third-nearest contracts.

52

Table I
Summary Statistics
This table presents summary statistics for returns, measures of volatility and changes in these measures, as well
as for measures of investment opportunities and operating flexibility used in cross-sectional tests. Returns data
are from CRSP. Accounting data are from COMPUSTAT. The sample period is 7/1963-12/2008. A stocks excess
return is the difference between its monthly return and monthly risk-free return. Volatility and its change refers
to monthly volatility of logarithmic daily returns. Book assets are in millions of dollars. Age is the difference
between the current year and the founding year, incorporation year, or the first year that the firms stock appears in
monthly CRSP files, in that order of availability. R&D / assets, is the ratio of R&D expenditures and lagged book
assets. Future sales growth is defined as the difference between sales four years after the year of the observation
over sales in the year following the year of the observation divided by sales in the year following the year of the
observation. Earnings convexity is the estimated coefficient on the squared earnings surprise in the firm-level
time-series regression of returns on earnings announcement days. Sales convexity is the estimated coefficient
on the squared sales surprise in the firm-level time-series regression of returns on earnings announcement days.
Union membership is at the industry level and is obtained from the Union Membership and Coverage database.

Mean

St. Dev.

P5

Median

P95

# Obs.

Excess Return

0.603

17.731

-21.709

-0.334

27.442

3,046,524

Volatility

3.172

2.539

0.669

2.453

8.443

3,070,953

Volatility

0.007

1.831

-2.884

-0.011

3.159

3,040,952

Book assets

2983.05

31470.78

3.91

107.65

8867.75

2,461,941

Age

28.383

31.915

1.000

13.322

96.864

3,062,722

R&D / assets

0.107

0.292

0.000

0.029

0.446

1,067,418

Future 3-year sales growth

2.818

19.982

-0.993

0.264

5.888

1,805,829

Earnings convexity

0.0268

1.2252

-1.2928

0.0044

1.3480

849,827

Sales convexity

0.2325

5.3051

-3.1685

0.0000

3.3917

746,283

Union membership

0.106

0.117

0.009

0.060

0.364

1,315,294

53

Table II
Returns and Contemporaneous Changes in Volatility
This table presents regressions of firm-level excess returns on the estimated loading on the market factor,
beginning-of-year log book-to-market ratio, log market equity, six-month lagged return for months -7 to -2 relative to the observation month, monthly trading volume normalized by the number of shares outstanding, and
month-to-month change in firm-level volatility, V OLi,t . The sample period is 7/1963 to 12/2008. We estimate
the regressions monthly and report time-series means of coefficient estimates along with t-statistics obtained using
Newey-West autocorrelation and heteroskedasticity consistent standard errors of monthly coefficient estimates in
parentheses. R2 refers to the average monthly R2 .

Market factor loading

0.298
(5.67)

0.217
(5.03)

0.300
(5.91)

0.2155
(5.25)

0.171
(4.04)

0.1075
(3.06)

Log(B/M)

0.413
(3.85)

0.383
(3.68)

0.406
(3.87)

0.380
(3.74)

0.770
(9.32)

0.717
(8.79)

Log(Equity value)

-0.141
(-2.71)

-0.130
(-2.59)

-0.152
(-2.93)

-0.138
( -2.78)

-0.142
(-2.91)

-0.1354
(-2.89)

0.0055
(4.41)

0.0057
(4.37)

-0.0015
(-1.15)

-0.0006
(-0.52)

2.972
(10.92)

2.476
(11.30)

Lag(6-month return)

Volume

Volatility

R2
# Months

1.308
(10.98)

1.315
(11.01)

1.186
(10.71)

0.036

0.071

0.041

0.077

0.076

0.105

539

539

539

539

539

539

54

Table III
Returns, Contemporaneous Changes in Volatility, and Investment Opportunities
This table presents regressions of firm-level excess returns on the estimated loading on the market factor,
beginning-of-year log book-to-market ratio, log market equity, six-month lagged return for months -7 to -2 relative
to the observation month, monthly trading volume normalized by the number of shares outstanding, month-tomonth change in firm-level volatility, V OLi,t , and an interaction variable equal to the product of V OLi,t
and one of the four investment opportunity measures: log(book assets), log(age), log(R&D to assets), and future
sales growth. See Section III for definitions of the investment opportunities measures. We normalize each of
the investment opportunity measures by subtracting its in-sample mean and dividing the difference by in-sample
standard deviation. The sample period is 7/1963 to 12/2008. We estimate the regressions monthly and report
time-series means of coefficient estimates along with t-statistics obtained using Newey-West autocorrelation and
heteroskedasticity consistent standard errors of monthly coefficient estimates in parentheses. R2 refers to the
average monthly R2 . We also present a summary of the economic effects of investment opportunity measures on
the V OLi,t -return relation. Low (high) investment opportunities means that the effect of V OLi,t on returns
is calculated using the value of the proxy for investment opportunities at two standard deviations below (above)
the mean. Large V OLi,t refers to V OLi,t that is two standard deviations above the mean; such change equals
3.66%.

55

Proxy for investment opportunities

Book assets

Age

R&D / assets

Future sales
growth

Market

0.120
(3.43)

0.106
(3.01)

0.147
(3.86)

0.134
(3.83)

Log(B/M)

0.733
(9.05)

0.709
(8.72)

0.703
(7.51)

0.637
(7.82)

Log(Equity value)

-0.128
(-2.72)

-0.139
(-2.99)

-0.155
(-3.28)

-0.174
(-3.73)

Lag(6-month return)

-0.001
(-0.61)

-0.001
(-0.47)

-0.001
(-0.39)

-0.001
(-0.44)

Volume

2.762
(11.27)

2.752
(11.19)

2.517
(10.35)

2.488
(10.76)

Volatility

0.967
(9.02)

1.213
(10.71)

1.102
(10.39)

1.220
(10.41)

-0.515
(-11.08)

-0.118
(-3.64)

0.120
(1.77)

0.273
(3.52)

0.109

0.107

0.123

0.108

539

539

539

521

High investment opportunities

1.997

1.449

1.342

1.766

Low investment opportunities

-0.063

0.977

0.862

0.674

High investment opportunities

7.31%

1.73%

4.91%

6.47%

Low investment opportunities

-0.23%

3.58%

3.16%

2.47%

Volatility * Investment opportunities

R2
# Months

Total effect of V OLi,t on return

Impact of large V OLi,t on return

56

Table IV
Returns, Contemporaneous Changes in Volatility, and Measures of Flexibility
This table presents regressions of firm-level excess returns on the estimated loading on the market factor,
beginning-of-year log book-to-market ratio, log market equity, six-month lagged return for months -7 to -2 relative
to the observation month, monthly trading volume normalized by the number of shares outstanding, month-tomonth change in firm-level volatility, V OLi,t , and an interaction variable equal to the product of V OLi,t and
one of the three flexibility measures: earnings convexity, sales convexity, and union membership. See Section IV
for details on estimation of the flexibility measures. We normalize each of the flexibility measures by subtracting
its in-sample mean and dividing the difference by the in-sample standard deviation. The sample period is 7/1985
to 12/2008. We estimate the regressions monthly and report time-series means of coefficient estimates along
with t-statistics obtained using Newey-West autocorrelation and heteroskedasticity consistent standard errors of
monthly coefficient estimates in parentheses. R2 refers to the average monthly R2 . We also present a summary
of the economic effects of the flexibility measures on the V OLi,t -return relation. Low (high) flexibility means
that the effect of V OLi,t on returns is calculated using the value of the proxy for flexibility at two standard
deviations below (above) the mean. Large V OLi,t refers to V OLi,t that is two standard deviations above the
mean; such change equals 3.66%.

57

Proxy for flexibility

Earnings convexity

Sales convexity

Union membership

Market

0.103
(1.99)

0.112
(2.14)

0.161
(2.31)

Log(B/M)

0.557
(4.85)

0.525
(4.78)

0.750
(2.26)

Log(Equity value)

-0.196
(-3.22)

-0.188
(-3.14)

-0.165
(-2.51)

Lag(6-month return)

-0.000
(-0.14)

-0.000
(-0.13)

-0.002
(-1.70)

Volume

1.251
(8.21)

1.211
(8.29)

1.218
(7.30)

Volatility

0.654
(6.92)

0.649
(7.00)

0.692
(6.87)

Volatility * Flexibility

0.052
(1.92)

0.066
(2.36)

-0.121
(-3.84)

R2

0.077

0.079

0.086

287

287

287

High flexibility

0.758

0.781

0.934

Low flexibility

0.550

0.517

0.450

High flexibility

2.78%

2.86%

3.42%

Low flexibility

2.01%

1.89%

1.65%

# Months

Total effect of V OLi,t on return

Impact of large V OLi,t on return

58

Table V
The Relation between Returns and Changes in Volatility around Investment Spikes
This table presents regressions of firm-level excess returns on the market factor, beginning-of-year log book-tomarket ratio, log market equity, six-month lagged return for months -7 to -2 relative to the observation month,
monthly trading volume normalized by the number of shares outstanding, and month-to-month change in firmlevel volatility, V OLi,t , estimated separately for subsamples of firms-months belonging to years [-2, 2] relative
to an investment-spike year, SEO, or a financing spike year. Specifically, for each firm-month we compute the
relative timing of the previous spike (SEO) and the next spike (SEO) and form five subsamples (four subsamples
for SEO firms), consisting of firms with two years to the next spike, one year to the next spike, the spike year,
one year after the spike, and two years after the spike (two years before the SEO and two years after). Panel A
presents results for investment spike firms. An investment spike is a firm-year in which a firms investment rate
is at least three times higher than its time-series median. Panel B presents results for SEO firms. The date of
an SEO is its filing date, or issue date if filing date is unavailable. Panel C presents results for financing spike
firms. Financing spikes are firm-years in which the combination of net new issues of equity and debt exceed 10%
of beginning-of-year book assets. The sample period is 1/1970 to 12/2008. We estimate the regressions monthly
and report time-series means of the coefficient on the change in volatility estimates along with their t-statistics
obtained using standard errors of monthly coefficient estimates in parentheses. The numbers in brackets are the
t-statistics for the differences between the estimated coefficient on the change in volatility in year 1 and that in
year -1 relative to the investment spike, SEO, or financing spike. We report similar results for matched firms,
defined in Section V. The difference row refers to the mean change in the coefficient on change in volatility between
year -1 and year 1 for sample firms minus that for matched firms, with t-statistics in parentheses.

Panel A. Investment spikes

Years since investment spike

-2

-1

Issuing firm

1.232
(3.78)

1.254
(7.97)

1.021
(7.70)

0.691
(5.78)
[2.85]

1.100
(6.56)

Matched firm

0.769
(3.12)

0.867
(6.31)

0.860
(6.76)

0.803
(5.69)
[0.32]

0.812
(5.32)

Difference

0.499
(1.78)

59

Panel B. SEOs

Years since SEO

-2

-1

Issuing firm

1.035
(3.28)

1.874
(13.65)

0.212
(1.40)
[8.13]

0.572
(2.71)

Matched firm

1.227
(3.65)

1.320
(10.14)

1.173
(9.01)
[0.80]

1.235
(9.55)

Difference

1.515
(5.51)

Panel C. Financing spikes

Years since financing spike

-2

-1

Issuing firm

0.724
(6.22)

1.253
(8.67)

0.711
(6.65)

0.583
(4.98)
[3.60]

1.270
(7.22)

Matched firm

0.783
(5.76)

0.822
(6.43)

0.798
(6.87)

0.766
(5.73)
[0.30]

0.771
(4.75)

Difference

0.614
(2.33)

60

Table VI
Returns, Contemporaneous Changes in Volatility, and Industry-Wide Real Option
Indicators
This table presents cross-sectional regressions of excess returns on the market factor, beginning-of-year log bookto-market ratio, log market equity, six-month lagged return for months -7 to -2 relative to the observation month,
monthly trading volume normalized by the number of shares outstanding, month-to-month change in firm-level
volatility, V OLi,t , and three interaction variables, defined as the product of V OLi,t and an indicator variable equal to one if a firms belongs to a high-tech industry, natural resources industry, and pharmaceutical or
biotechnology industry respectively. The sample period is 7/1963 to 12/2008. We define high-tech industries as
Fama-French (1997) industries 22 (electrical equipment), 32 (telecommunications), 35 (computers), 36 (computer
software), 37 (electronic equipment), and 38 (measuring and control equipment). We define natural resources
industries as Fama-French industries 27 (precious metals), 28 (mining), and 30 (oil and natural gas). We define
pharmaceutical and biotechnology industries as Fama-French industries 12 (medical equipment) and 13 (pharmaceutical products). We estimate the regressions monthly and report time-series means of coefficient estimates
along with t-statistics obtained using Newey-West autocorrelation and heteroskedasticity consistent standard errors of monthly coefficient estimates in parentheses. R2 refers to the average monthly R2 . We also present the
impact of large V OLi,t on returns for various industry groups. Large V OLi,t refers to V OLi,t that is two
standard deviations above the mean; such change equals 3.66%.

61

Market

0.108
(3.09)

Log(B/M)

0.715
(8.89)

Log(Equity value)

-0.131
(-2.81)

Lag(6-month return)

-0.001
(-0.58)

Volume

2.751
(11.26)

Volatility

0.826
(7.08)

Volatility * High tech

0.383
(4.25)

Volatility * Natural resources

0.400
(4.01)

Volatility * Pharmaceuticals

0.242
(2.35)

R2

0.110

# Months

539

Impact of large V OLi,t on return

High tech

4.43%

Natural resources

4.49%

High tech

3.91%

High tech

3.02%

62

Table VII
Returns of Oil and Gas Firms and Contemporaneous Changes in Volatility of Oil
Returns
This table presents panel regressions of oil and gas firms excess returns on the market factor, beginning-of-year
log book-to-market ratio, log market equity, six-month lagged return for months -7 to -2 relative to the observation
month, monthly trading volume normalized by the number of shares outstanding, monthly relative change in oil
price (monthly oil return), month-to-month change in oil price volatility, and interaction variables equal to the
product of the proportion of undeveloped oil/gas/total reserves and month-to-month change in oil price volatility.
The sample period is 1/1995 to 12/2009. Oil and gas firms are those belonging to Fama-French (1997) industry
30. Relative oil price changes and their volatilities are computed using Brent Crude oil daily prices. See Section
VI for a discussion of developed and undeveloped reserves. Standard errors are clustered by month. We also
present a summary of the economic effects of the proportion of undeveloped reserves on the OILV OLi,t -return
relation. No (high) undeveloped reserves means that the effect of OILV OLi,t on returns is calculated using the
value of the proxy for the proportion of undeveloped reserves at zero (two standard deviations above the mean).
Large OILV OLi,t refers to OILV OLi,t that is two standard deviations above the mean; such change equals
1.95%.

63

Type of undeveloped reserves

Oil

Gas

Total

Market

0.096
(0.97)

0.060
(0.61)

0.059
(0.60)

0.065
(0.66)

Log(B/M)

1.210
(2.92)

1.236
(3.00)

1.224
(2.96)

1.211
(2.93)

Log(Equity value)

-0.676
(-7.64)

-0.643
(-7.29)

-0.656
(-7.43)

-0.655
(-7.42)

Lag(6-month return)

0.010
(2.39)

0.010
(2.41)

0.010
(2.48)

0.010
(2.43)

Volume

1.857
(12.33)

1.735
(11.53)

1.783
(11.84)

1.784
(11.84)

Relative oil price change

0.427
(22.78)

0.425
(22.79)

0.427
(22.84)

0.427
(22.83)

Oil volatility

0.652
(3.38)

0.489
(2.53)

0.553
(2.86)

0.559
(2.90)

Prop. undev. reserves * Oil volatility

2.659
(8.70)

Prop. undev. reserves * Oil volatility

2.271
(6.79)

Prop. undev. reserves * Oil volatility

1.838
(6.30)

R2

0.081

0.089

0.086

0.085

# Observations

8,192

8,192

8,192

8,192

High undev. reserves

2.324

2.075

1.809

No undev. reserves

0.489

0.553

0.559

High undev. reserves

4.53%

4.04%

3.53%

No undev. reserves

0.95%

1.08%

1.09%

Total effect of OILV OLi,t on return

Impact of large OILV OLi,t on return

64

65

Intercept
MKTRF

Intercept
MKTRF

Intercept
MKTRF

Intercept
MKTRF

Intercept
MKTRF

Rank coeff
on Volatility

Rank beta

0.104
0.833

0.261
0.661

0.172
0.780

0.270
0.643

0.210
0.671

(0.77)
(28.69)

(2.18)
(25.56)

(1.49)
(31.37)

(2.25)
(24.79)

(1.57)
(23.29)

0.357
0.767

0.135
0.757

0.126
0.807

0.137
0.769

0.088
0.758

(2.65)
(26.43)

(1.12)
(29.29)

(1.10)
(32.46)

(1.14)
(29.63)

(0.66)
(26.32)

-0.030
0.917

0.123
0.953

0.143
0.954

0.107
0.901

0.022
1.053

Panel A. CAPM

(-0.22)
(31.61)

(1.03)
(36.86)

(1.24)
(38.36)

(0.89)
(34.73)

(0.16)
(36.55)

0.209
1.135

0.054
1.133

-0.087
1.196

-0.277
1.233

-0.215
1.296

(1.55)
(39.09)

(0.45)
(43.83)

(-0.75)
(48.12)

(-2.01)
(47.53)

(-1.61)
(44.98)

-0.552
1.535

-0.300
1.535

-0.212
1.476

-0.241
1.517

-0.137
1.631

(-4.11)
(52.88)

(-2.51)
(59.36)

(-1.84)
(59.35)

(-2.01)
(58.47)

(-1.03)
(56.58)

5.40

2.72

1.79

3.30

1.32

GRS Test

0.250

0.175

0.148

0.206

0.135

Mean pricing
error

This table presents coefficient estimates of time-series regressions of monthly value-weighted excess returns of 25 portfolios sorted on estimated market
betas and coefficients on changes in volatility, V OLi,t , on the excess return on the market portfolio in Panel A and on the Fama and French (1993)
three factors in Panel B. t-statistics are reported in parentheses to the right of each coefficient. The sample period is 7/1963 to 12/2008. Within
each V OLi,t quintile, we compute the mean pricing error, defined as the mean absolute value of the intercepts in the five beta groups, and the
Gibbons-Ross-Shanken (GRS) statistic for testing whether the pricing errors of the five beta portfolios within each real options quintile are jointly zero.

Table VIII
Asset pricing tests

66

Intercept
MKTRF
HML
SMB

Intercept
MKTRF
HML
SMB

Intercept
MKTRF
HML
SMB

Intercept
MKTRF
HML
SMB

Intercept
MKTRF
HML
SMB

Rank coeff
on Volatility

Rank beta

0.067
0.815
0.042
0.149

0.109
0.693
0.246
0.168

0.112
0.806
0.104
0.009

0.134
0.715
0.246
-0.033

0.118
0.726
0.171
-0.046

(0.52)
(27.12)
(0.91)
(3.68)

(0.99)
(26.77)
(6.18)
(4.78)

(1.03)
(31.25)
(2.64)
(0.27)

(1.22)
(27.33)
(6.13)
(-0.93)

(0.94)
(24.86)
(3.84)
(-1.18)

0.191
0.845
0.294
0.002

0.036
0.850
0.206
-0.191

0.014
0.905
0.230
-0.184

-0.006
0.862
0.272
-0.104

-0.047
0.845
0.256
-0.097

(1.50)
(28.14)
(6.40)
(0.06)

(0.33)
(32.79)
(5.19)
(-5.44)

(0.12)
(35.09)
(5.82)
(-5.30)

(-0.06)
(32.94)
(6.77)
(-2.93)

(-0.38)
(28.96)
(5.71)
(-2.47)

-0.190
1.006
0.294
-0.054

0.015
1.016
0.201
-0.050

0.020
1.024
0.227
-0.048

-0.020
0.993
0.247
-0.135

-0.072
1.090
0.162
0.033

(-1.49)
(33.51)
(6.38)
(-1.33)

(0.13)
(39.23)
(5.06)
(-1.43)

(0.18)
(39.70)
(5.73)
(-1.38)

(-0.18)
(37.96)
(6.14)
(-3.81)

(-0.58)
(37.32)
(3.61)
(0.83)

0.101
1.157
0.172
0.119

-0.069
1.180
0.211
0.049

-0.165
1.191
0.112
0.181

-0.287
1.196
-0.011
0.178

-0.151
1.215
-0.148
0.211

Panel B. Fama-French three-factor model

4

(0.80)
(38.53)
(3.74)
(2.93)

(-0.63)
(45.56)
(5.32)
(1.38)

(-1.51)
(46.17)
(2.82)
(5.18)

(-2.59)
(45.69)
(-0.27)
(5.02)

(-1.22)
(41.61)
(-3.31)
(5.34)

-0.493
1.365
-0.200
0.591

-0.234
1.357
-0.214
0.613

-0.146
1.337
-0.189
0.450

-0.102
1.329
-0.329
0.511

0.021
1.409
-0.380
0.613

(-3.87)
(45.46)
(-4.33)
(14.55)

(-2.13)
(52.39)
(-5.40)
(17.50)

(-1.34)
(51.84)
(-4.78)
(12.91)

(-0.92)
(50.79)
(-8.20)
(14.45)

(0.17)
(48.24)
(-8.48)
(15.52)

4.07

1.21

1.03

1.81

0.58

GRS Test

0.208

0.093

0.091

0.110

0.082

Mean pricing
error

Table IX
Time Series Regressions
Panel A presents regressions of aggregate (value-weighted) monthly excess return on aggregate volatility and
month-to-month change in aggregate volatility. Aggregate volatility and change in it refers to the volatility of the
value-weighted monthly return on all listed stocks. Panel B presents regressions of firm-level excess returns on
changes in aggregate volatility and the Fama and French (1993) three factor returns (MKTRF, HML, and SMB).
Panel C presents regressions of firm-level excess returns on changes in aggregate volatility and the Fama and
French (1993) three factor returns for subsamples of firms grouped by measures of investment opportunities and
by measures of flexibility. Only the coefficients on the change in volatility are reported. The last column reports
the difference between the estimated coefficients on the change in aggregate volatility between the extreme real
options groups. The sample period is 7/1963 to 12/2008. t-statistics are reported in parentheses. In Panel A,
t-statistics are obtained using Newey-West autocorrelation and heteroskedasticity-consistent standard errors. We
estimate panel regressions in Panels B and C and cluster standard errors by month.

Panel A. Dependent variable - aggregate excess return

Aggregate volatility

-3.06
(-8.57)

Aggregate volatility

-3.88
(-8.65)

R2

0.118

0.122

540

539

# Observations

Panel B. Dependent variable - firm-level excess return

Aggregate volatility

-6.87
(-3.36)

MKTRF

-2.33
(-1.02)

0.01
(0.00)

1.18
(8.93)

1.08
(5.67)

HML

0.23
(0.98)

SMB

1.27
(6.12)

R2
# Observations

67

0.010

0.040

0.058

3,040,952

3,040,952

3,040,952

Panel C. Dependent variable - firm-level excess return. By real option groups

Ranking

5-1

-0.175
(-7.50)

-0.635
(-6.61)

-0.244
(-10.37)

-0.470
(-6.22)

0.719
(4.05)

0.715
(3.67)

0.672
(8.25)

0.555
(5.14)

0.349
(4.23)

0.254
(2.74)

0.265
(2.52)

0.152
(1.35)

-0.509
(-4.05)

-0.650
(-4.62)

Book assets
Aggregate volatility

0.460
(4.94)

0.205
(4.65)

-0.037
(-1.05)

-0.250
(-6.84)

Age
Aggregate volatility

0.226
(3.15)

0.564
(8.71)

0.137
(2.49)

0.005
(0.14)

RD/ assets
Aggregate volatility

0.004
(0.05)

0.405
(4.06)

0.400
(3.98)

0.809
(5.82)

Future sales growth

Aggregate volatility

0.117
(1.65)

0.000
(0.01)

0.085
(1.56)

0.355
(5.77)

Earnings convexity
Aggregate volatility

0.095
(2.25)

-0.086
(-1.87)

-0.082
(-1.50)

0.393
(6.19)

Sales convexity
Aggregate volatility

0.113
(2.86)

-0.044
(-1.10)

0.105
(1.91)

0.013
(0.22)

Union membership
Aggregate volatility

0.141
(2.24)

0.496
(3.24)

68

0.312
(2.11)

-0.683
(-6.94)