Optimal investment, growth options, and security returns

As a consequence of optimal investment choices, a firm's assets and growth options change in predictable ways. Using a dynamic model, we show that thi s imparts predictability to changes in a firm's systematic risk, and its ex pected return. Simulations show that the model simultaneously reproduces: ( i) the time-series relation between the book-to-market ratio and asset retu rns; (ii) the cross-sectional relation between book-to-market, market value , and return; (iii) contrarian effects at short horizons; (iv) momentum eff ects at longer horizons; and (v) the inverse relation between interest rate s and the market risk premium.