INVESTMENT GROWTH OPTIONS - A SIMPLE

MODEL OF ENDOGENOUS STOCHASTIC VOLATILITY

Shashidhar Murthy
Indian Institute of Management Bangalore

9th Annual Conference on Economic Growth and Development

ISI, New Delhi, December 19 - 21, 2013

1
 What we do & Why
• ARCH, GARCH-type econometric models for
volatility are common

• This paper provides a firm-level structural

model and economic rationale for above

2
 Motivation
• Why should variances be stochastic, and autocorrelated?

• Most common rationale offered: exogenous shocks (e.g. to

conditional expectations) are assumed to be autocorrelated.
– Can’t IID structure yield results depending on context - stock returns
vs. inflation vs. exchange rates?
• A few economic justifications exist (also see next slide):
– Institutional: market micro-structure; incomplete markets
– Demand-side: preference structure; investor heterogenity; learning;
time-varying risk premia
– Prominent exception: Granger & Machina, “Structural Attribution of
Observed Volatility Clustering”, Journal of Econometrics, 2006

• We add to above with model of firm’s investment choice and offer

simple, intuitive, economic rationale. Derive endogenous ARCH-
type behaviour

3
 Related literature
• Explanations for endogenous ARCH are few
– Market micro-structure reasons. Explain at low
frequencies?
– Preferences (habit formation, etc). Cross-sectional
implications?
– Learning: rational updating (or alternatives).
Applies in all contexts, all firms?
• Exception – Granger & Machina (2006). Show
examples with IID exogenous shocks + Non-
linear response to shocks yield volatility
clustering.
4
 Overview - Model & Results
• A firm has (1) installed capital, and (2) options to add
capital in future
– Firm value = value of (1) + value of (2)
– Returns , and variance, depend on “mix” of (1) & (2)

• Firm’s investment choices over time:

– are non-linear in exogenous state (given irreversibility of
investments)
– change the above “mix” dynamically and, thereby,
– produce stochastic variance of returns
– yield autocorrelation in variances

• Thus, simple structure of IID external shocks + Non-linearity

to shocks is sufficient for ARCH-type behaviour

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 Model - Structure
• Typical firm; partial equilibrium (given SDF)
• Installed capital yields output in a “AK-like”
fashion
• Firm adds to capital over time
• Each investment “project”: fixed size or
indivisible; irreversible
• Resulting “Options to invest” induces non-
linear response of firm value to shocks
• Firm value P(t) = PV of future output from (1)
Assets-in-place & (2) Growth Options
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 Projects (indivisible & irreversible)
At each date j, a project arrives. Investment i. If take project, capital depreciates
deterministically:
  =  −

Output of project j at date t =   
  

Productivity of project j is IID. Projection on aggregate priced risk factor (i.e. SDF)

   =  +  1 −   +  ;  ≥  + 1; { } IID

Projection parameters & Risk-adjusted mean productivity are ex-ante

identical over future projects. Realizations are IID across projects.

 +
Stochastic discount factor:  
=  −1 ∏=1  + ; {} IID;   = 1

I.e. interest rate & market price of risk are constant

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 Value & Returns of each Project
Value of output at t+1:
 + 1
    + 1
  + 1

=  −1
  + 1   + 1   + 1!

=  −1
  + 1  − 2
 "  ≡  −1
  + 1%

Value at t of all future output: &   =
  + 1% / − 

Project returns   + 1 ≡ (  + 1 + &  + 1!/&  

Variance of project returns

&)*   + 1! = +21 "2 + +22 ",

2
≠ &)* .  + 1

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 Options – exercise & value
Optimal investment decision: take project i.f.f. &   > 

Invest iff % risk-adjusted mean productivity is high enough

Value at t of growth option at t+1:

  +1
 0   
max {& +1  + 1 − , 0}6

where & +1  + 1 = % +1 / − 

;

Assumption: {% } is IID.

89 over time
Hence value of all future GOs is ex-ante constant 7

Returns of GOs are IID:

9  + 1 ≡ 79  + 1 + max {& +1  + 1 − , 0}/79  

Variance of GO returns is constant

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 Firm as a Portfolio
• Value and returns of firm = Value and returns of
changing portfolio of Assets-in-place and Growth
Options
• Variance of firm returns = dynamically changing
average of AIP variance & GO variance
• Value and returns of Assets-In-Place = Value and
returns of changing portfolio of projects
• Variance of AIP returns = complex changing
average of project variances?

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 Pure Scaling
• Assume: a firm grows by a pure expansion of scale. Arguably applicable
to many businesses. Any two projects’ outputs or earnings are perfectly
correlated with each other.

Let    = :  where : is the "quality" of the

project born at date j. {:  } is IID over time
Common prdctvty:
  = ) + ) 1 −    + )  ; {)  } IID
Value at t of all future output: &   =
  + 1% / − 

•Betas, residual standard devs, & variances of returns of different projects

equal each other, and hence, = variance of A-I-P = constant

•Optimal investment decision, Growth option valuation, and properties -

similar to before
•Now : covariance of GO and AIP returns = constant
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 Dynamics of Firm Variables
Value of Asset-In-Place:

7)  + 1 = ∑ =0 ? &  + 1 + ?  + 1&+1  + 1

= value of previous projects + possibly new project at t+1

= 7)   + (2), given same depreciation factor  for all projects.

(2) = &+1  + 1 ∗ <{&+1  + 1 > }; where <{. } = event { new investment}

= %: + 1<{: + 1 > /%}

= %: + 1<{: + 1 > /%} + @ + 1, uncond mean + orthog error

Hence: AR-1 7)  + 1 = ) + 7)  + @ + 1

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 Dynamics of Firm Variables (2)

Recall: firm value 7 = 7)  + 789

Hence 7 + 1 =  + 7 + @ + 1

Lemma 5: {7) } and firm value {7} have endogenous linear and
Markov and, in particular, AR-1 transition dynamics. Transition
probabilities converge; a stationary distribution exists with finite
moments. .

Key: endogenous state variable that summarizes all history

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 Dynamics – Role of Growth Options

Since 7   = 7)   + 79  , changes in the weight

A   = 79  /7  drive the changing risk-return attributes
of firm

Lemma 6: The relative importance {A} of growth options to firm value

follows a 1st-order stationary Markov process with transition dynamics given
by

A  
A + 1 =  + @ +1
 +  B9 A  
7

Furthermore, A + 1 is strictly increasing in A.

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 Dynamics of Firm Return Variance

Conditional variance of the firm’s returns

"2 = A 2 "92 + 1 − A2 ")2 + 2A 1 − A ")9 !

Firm risk firm varies with the relative importance of growth options:

C"2 /CA = 2A  "92 + ")2 − 2")9 ! + 2")9 − ")2  = (>0) + (?)

Commonplace intuition: risk of option on an asset >= risk of asset. Suggests ")9 ≥ ")2 natural restriction.

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 Main result
Theorem 1: Restrict the underlying exogenous shocks’ distributions such
that ")9 ≥ ")2 . Then the firm return variance "2 is strictly increasing in
A, the relative importance of growth options in firm value. Using
Lemma 6, it follows that the firm return variance process is non-IID and, in
particular, 1st-order Markov. Furthermore {"2 } possesses a limiting
stationary distribution.

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 Time-series properties of return variances
• Consistent with 3 empirical stylized facts
Corollary 1: The variance process exhibits (a) positive
autocorrelations or clustering, (b) the “leverage effect” that
the current variance is decreasing in the contemporaneous
stock return, and (c) a mean reverting tendency.

Positive autocorrelation: Saw A  + 1 is strictly increasing in A . With

positive C"2 /CA , this implies that future variances are strictly
increasing in the current variance. Use first-order stochastic dominance.

“Leverage” effect: in good times (high productivity shocks), invest, &

get high returns. This also lowers role for future growth, i.e. lowers
A  . Since vol is increasing in A , get negative relationship
between returns and variance.

Mean revering tendency: a monotone transform of variance follows an AR-1

process.

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 Conclusions
• Model with simple non-linear structure and IID shocks produces
stochastic variances with time-series patterns

• Consistent with stylized facts from ARCH/GARCH literature

• Also consistent with evidence (old) that small firm returns and
(recent) firms with growth options are more volatile

• Testable cross-sectional implications: ARCH-type parameters should

be related to growth option measures

• Extensions?
– When Pure Scaling assumptions are not met, 2 endogenous state
variables needed. I.e. Past and current variances = sufficient statistic?
– General equilibrium?

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