Real options and optimal investment decisions

Abstract

Using a dynamic model based on growth options and through simulations Berk, Green and Naik show that the model simultaneously reproduces the cross-sectional relation between book-to-market, size and asset return. The model also reproduces momentum and contrarian strategies. However some coefficients in the cross-sectional relations are statistically insignificant and the time horizons for momentum and contrarian strategies are significantly different from the numbers reported in the financial literature. By making suitable adjustments to BGN model we show that our model captures a more realistic view of firms and has the potential to correct one or more of the above differences.