Continuation Call Options and the Sensitivity of Returns to Gains

Abstract

Complementing prior literature that examines determinants of the sensitivity of returns to losses, we provide evidence that the sensitivity of returns to gains increases with firms’ real continuation call options, i.e., their discretionary ability to continue operations, to make new investments, and to raise capital when financing deficits arise. To ensure that our findings are incremental to those reported in prior literature, we estimate the sensitivity of returns to losses and gains using spline regressions for sequential partitions of the sample based on proxies for general optionality, liquidation likelihood, investment in real continuation call options, and financing of those investments. We find that the investment and financing of real continuation call options partitions primarily explain the sensitivity of returns to gains and that, despite their subordinated position in this sequence, these partitions have more explanatory power over the returns-earnings relation than do the general optionality and liquidation likelihood partitions. We conduct analyses that validate our measures of the sensitivity of returns to gains as capturing firms’ real continuation call options. Collectively, our results enhance our understanding of how optionality influences the returns-earnings relation.