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

5
 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
6
 Projects (indivisible & irreversible)
At each date j, a project arrives. Investment i. If take project, capital depreciates
deterministically: 𝐾𝑗 ሺ𝑡ሻ = 𝑖𝜋 𝑡−𝑗

Output of project j at date t = 𝐴𝑗 ሺ𝑡ሻ𝐾𝑗 ሺ𝑡ሻ

Productivity of project j is IID. Projection on aggregate priced risk factor (i.e. SDF)
𝐴𝑗 ሺ𝑡ሻ = 𝜇𝑗 + 𝛽𝑗 ሾ1 − 𝜈 ሺ𝑡ሻሿ+ 𝜀𝑗 ሺ𝑡ሻ; 𝑡 ≥ 𝑗 + 1; {𝜀𝑗 ሺ𝑡ሻ} IID

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

identical over future projects. Realizations are IID across projects.

𝑚 (𝑡+𝑠) 𝑠
Stochastic discount factor: = 𝑅−1 ς 𝑢=1 𝜈 ሺ𝑡 + 𝑢ሻ; {𝜈ሺ𝑡ሻ} IID; 𝐸 ሾ𝜈 ሺ𝑡ሻሿ= 1
𝑚 (𝑡)

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

7
 Value & Returns of each Project
Value of output at t+1:
𝑚(𝑡 + 1)
𝐸𝑡 ൤ 𝐴𝑗 ሺ𝑡 + 1ሻ𝐾𝑗 ሺ𝑡 + 1ሻ൨
𝑚(𝑡)
= 𝑅 −1 𝐾𝑗 ሺ𝑡 + 1ሻ𝐸𝑡 ൣ𝜈 ሺ𝑡 + 1ሻ𝐴𝑗 ሺ𝑡 + 1ሻ൧

= 𝑅 −1 𝐾𝑗 ሺ𝑡 + 1ሻ(𝜇𝑗 − 𝛽𝑗 𝜎𝜈2 ) ≡ 𝑅 −1 𝐾𝑗 ሺ𝑡 + 1ሻ𝛼𝑗

Value at t of all future output: 𝑉𝑗 ሺ𝑡 ሻ = 𝐾𝑗 ሺ𝑡 + 1ሻ𝛼𝑗 /(𝑅 − 𝜋)

Project returns 𝑅𝑗 ሺ𝑡 + 1ሻ ≡ ൣ𝑦𝑗 ሺ𝑡 + 1ሻ + 𝑉𝑗 ሺ𝑡 + 1ሻ൧/𝑉𝑗 ሺ𝑡 ሻ

Variance of project returns

𝑉𝑎𝑟𝑡 ൣ𝑅𝑗 ሺ𝑡 + 1ሻ൧= 𝑏𝑗21 𝜎𝜈2 + 𝑏𝑗22 𝜎𝜖𝑗

2
≠ 𝑉𝑎𝑟𝑡 ሾ𝑅𝑘 ሺ𝑡 + 1ሻሿ

8
 Options – exercise & value
Optimal investment decision: take project i.f.f. 𝑉𝑗 ሺ𝑗 ሻ > 𝑖

Invest iff 𝛼𝑗 risk-adjusted mean productivity is high enough

Value at t of growth option at t+1:

𝑚 (𝑡 +1)
𝐸𝑡 ቂ max⁡{𝑉𝑡 +1 ሺ𝑡 + 1ሻ − 𝑖, 0}ቃ
𝑚 (𝑡 )

where 𝑉𝑡 +1 ሺ𝑡 + 1ሻ = 𝑖𝛼𝑡 +1 /(𝑅 − 𝜋);

Assumption: {𝛼𝑡 } is IID.

ത
Hence value of all future GOs is ex-ante constant 𝑃𝑔 over time

Returns of GOs are IID:

𝑅𝑔 ሺ𝑡 + 1ሻ ≡ [𝑃𝑔 ሺ𝑡 + 1ሻ + max⁡{𝑉𝑡 +1 ሺ𝑡 + 1ሻ − 𝑖, 0}]/𝑃𝑔 ሺ𝑡 ሻ

Variance of GO returns is constant

9
 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?
10
 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 𝐴𝑗 ሺ𝑡 ሻ = 𝜆ሺ𝑗ሻ𝐴(𝑡) where 𝜆ሺ𝑗ሻ is the "quality" of the

project born at date j. {𝜆 ሺ𝑡 ሻ} is IID over time
Common prdctvty:
𝐴ሺ𝑡 ሻ = 𝜇𝑎 + 𝛽𝑎 ሾ1 − 𝜈 ሺ𝑡 ሻሿ+ 𝜀𝑎 ሺ𝑡 ሻ; {𝜀𝑎 ሺ𝑡 ሻ} IID
Value at t of all future output: 𝑉𝑗 ሺ𝑡 ሻ = 𝐾𝑗 ሺ𝑡 + 1ሻ𝛼𝑗 /(𝑅 − 𝜋)

•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
11
 Dynamics of Firm Variables

Value of Asset-In-Place:

𝑃𝑎 ሺ𝑡 + 1ሻ = σ 𝑡𝑗 =0 𝜉 ሺ𝑗ሻ𝑉𝑗 ሺ𝑡 + 1ሻ + 𝜉 ሺ𝑡 + 1ሻ𝑉𝑡+1 ሺ𝑡 + 1ሻ

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

= 𝜋𝑃𝑎 ሺ𝑡ሻ + (2), given same depreciation factor 𝜋 for all projects.

(2) = 𝑉𝑡+1 ሺ𝑡 + 1ሻ ∗ 𝐼{𝑉𝑡+1 ሺ𝑡 + 1ሻ > 𝑖}; where 𝐼{. } = event { new investment}

= 𝜋𝛼𝜆ሺ𝑡 + 1ሻ𝐼{𝜆(𝑡 + 1) > 𝑖/𝜋𝛼}

= 𝜋𝛼𝐸[𝜆ሺ𝑡 + 1ሻ𝐼{𝜆(𝑡 + 1) > 𝑖/𝜋𝛼}] + 𝜂(𝑡 + 1), uncond mean + orthog error

Hence: AR-1 𝑃𝑎 ሺ𝑡 + 1ሻ = 𝑚𝑎 + 𝜋𝑃𝑎 ሺ𝑡ሻ + 𝜂ሺ𝑡 + 1ሻ

12
 Dynamics of Firm Variables (2)

Recall: firm value 𝑃ሺ𝑡ሻ = 𝑃𝑎 ሺ𝑡ሻ + 𝑃ത

𝑔

Hence 𝑃ሺ𝑡 + 1ሻ = 𝑚 + 𝜋𝑃ሺ𝑡ሻ + 𝜂ሺ𝑡 + 1ሻ

Lemma 5: {𝑃𝑎 ሺ𝑡ሻ} and firm value ሼ𝑃ሺ𝑡ሻሽ 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

13
 Dynamics – Role of Growth Options

Since 𝑃 ሺ𝑡 ሻ = 𝑃𝑎 ሺ𝑡 ሻ + 𝑃𝑔 ሺ𝑡 ሻ, changes in the weight

𝑤 ሺ𝑡 ሻ = 𝑃𝑔 ሺ𝑡 ሻ/𝑃ሺ𝑡 ሻ drive the changing risk-return attributes
of firm

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

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

𝑤 ሺ𝑡 ሻ
𝑤ሺ𝑡 + 1ሻ = 𝑚 + 𝜂 ሺ𝑡+1ሻ
𝜋 + ൤ ഥ𝑔 ൨𝑤 ሺ𝑡 ሻ
𝑃

Furthermore, 𝑤ሺ𝑡 + 1ሻ is strictly increasing in 𝑤ሺ𝑡ሻ.

14
 Dynamics of Firm Return Variance

Conditional variance of the firm’s returns

𝜎𝑡2 = 𝑤 2 ሺ𝑡ሻ𝜎𝑔2 + [1 − 𝑤ሺ𝑡ሻ]2 𝜎𝑎2 + 2𝑤ሺ𝑡ሻൣ1 − 𝑤 ሺ𝑡ሻ𝜎𝑎𝑔 ൧

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

𝜕𝜎𝑡2 /𝜕𝑤ሺ𝑡ሻ = 2𝑤 ሺ𝑡ሻൣ𝜎𝑔2 + 𝜎𝑎2 − 2𝜎𝑎𝑔 ൧+ 2[𝜎𝑎𝑔 − 𝜎𝑎2 ] = (>0) + (?)

Commonplace intuition: risk of option on an asset >= risk of asset. Suggests 𝜎𝑎𝑔 ≥ 𝜎𝑎2 natural restriction.

15
 Main result
Theorem 1: Restrict the underlying exogenous shocks’ distributions such
that 𝜎𝑎𝑔 ≥ 𝜎𝑎2 . Then the firm return variance 𝜎𝑡2 is strictly increasing in
𝑤ሺ𝑡ሻ, 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 {𝜎𝑡2 } possesses a limiting
stationary distribution.

16
 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 𝑤 ሺ𝑡 + 1ሻ is strictly increasing in 𝑤 ሺ𝑡ሻ. With
positive 𝜕𝜎𝑡2 /𝜕𝑤 ሺ𝑡ሻ, 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
𝑤 ሺ𝑡 ሻ. Since vol is increasing in 𝑤 ሺ𝑡ሻ, get negative relationship
between returns and variance.

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

process.

17
 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? 18