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Growth Options, Equity Risk and Returns: Evidence from Pharmaceutical and Biotechnology Firms

Recent real options models predict that a creation and exercise of growth options are important determinants of firms’ riskiness and expected returns. I test these predictions by examining firm-level risk and return dynamics around two discrete and economically important instances of the creation and exercise of growth options: the approvals of highly-innovative new drugs and awards of patents underlying these drugs. I find that both events are associated with a significant short and medium-term increase in stock prices. The magnitude of the stock price reaction is positively related to the value of growth options embedded in both events. The systematic and idiosyncratic equity risk increases following the patent awards and the idiosyncratic equity risk decreases following the drug approvals. However, I find no evidence that the equity risk changes are systematically related to the stock prices changes.