Growth Options in General Equilibrium: Some Asset Pricing Implications

We develop a general equilibrium model of a production economy which has a risky production technology as well as a growth option to expand the scale of the productive sector of the economy. We show that when confronted with growth options, the representative consumer may sharply alter consumption rates to improve the likelihood of investment. This reduction in consumption is accompanied by an erosion of the option value of waiting to invest, leading to investment near the zero NPV threshold. It also has important consequences for the evolution of risk aversion, asset prices and equilibrium interest rates which we characterize in this paper. One interesting prediction of the model is that we get time varying risk aversion and equity returns by virtue of the presence of growth option. We also find that the moneyness of the growth option is the key factor which determines the extent to which the book to market ratios will influence the conditional moments of equity returns.