Growth to value: Option exercise and the cross section of equity returns

We put forward a model that links the cross-sectional variation in expected equity returns to firms ’ life cycle dynamics. We show that value premium arises naturally in equilibrium under two simple conditions: inelastic supply of investment in physical capital and mean reverting aggregate risk. Growth assets in the model are options on assets in place (i.e., value assets). The cost of option exercise, endogenously determined in equilibrium, is highly sensitive to aggregate consumption risks. This provides a hedge against risks in assets in place, making growth options less risky than value assets. Our model features long-run consumption risks (as in Bansal and Yaron (2004)) and replicates the empirical failure of the traditional CAPM and CCAPM. We calibrate the model and show that it is able to account for the observed pattern in mean returns on book-to-market sorted portfolios