Real options' effects on stock returns - European evidence

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School of Business | Master's thesis
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This thesis has two main objectives. First objective is to show that there exists positive relation between stock return and contemporaneous idiosyncratic volatility in European sample, in line with previous research on US data. Second objective is to research real options as possible cause of this positive contemporaneous return-volatility relation in individual stocks. The data includes publicly traded Western European stocks with daily price data together with relevant accounting and other data. The time period of the research is from January 1990 to December 2011. Real options are proxied at the individual company level with size, age, R&D intensity, future three year sales growth, Tobin's q and B/M ratio. In mining industry real options are proxied with amount of metal and ore reserves and in pharmaceutical industry with amount of drugs in clinical trial pipeline. I use panel data regression approach as the research method. In this thesis I find positive relation between return and contemporaneous idiosyncratic volatility in the researched sample. The results are mainly supportive for the real option hypothesis from many perspectives. I show significant interaction between multiple real option proxies and volatility change in regressions on monthly excess return. I show that this interaction is driven by the companies that presumably have the most real options: small, young, high growth, high R&D and high Tobin's q companies. I find that presumably the companies in the most real option intensive industries, namely oil and gas, high technology, healthcare and basic materials have the highest volatility change coefficient in monthly regressions on excess returns. I show that mining industry specific novel real option proxy ratio of reserves to yearly production has significant and positive interaction coefficient with volatility change in regressions on monthly excess returns. I also show how return-volatility relation develops around real option exercise proxied by SEO: in the years before SEO there is significant positive relation, which disappears at and especially one year after SEO, and builds up again two years after SEO. Results of this thesis are generally in line with the previous research of the US data. Despite some mixed results, the results presented here are mainly supporting for the real option hypothesis. Therefore, it can be concluded that real options are an important factor causing positive relation between return and contemporaneous idiosyncratic volatility.
real options, return-volatility relation, contemporaneous volatility
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