REAL OPTIONS AND THE CROSS-SECTION OF EXPECTED STOCK RETURNS

This paper surveys the theoretical literature investigating the effect of firms' investment flexibility on the cross-section of expected stock returns. Real options analysis derives firms' value-maximizing investment policies as functions of exogenous fundamental drivers of profitability and calculates firms' market values as functions of the same variables. These functions yield the relationship between expected stock returns and firm fundamentals. Several plausible explanations for the value premium - the high average stock returns earned by firms with high book-to-market ratios - emerge from this literature.