Mispricing or Risk Premium? An Explanation of the R&D-to-Market Anomaly

Abstract

Two contrasting explanations are offered in the literature for the R&D-to-market anomaly: mispricing of R&D resulting from limited investor attention to R&D spending, and the failure of conventional risk factors to completely capture the risk associated with R&D. Exploiting accounting treatments in Korea, in which R&D expenditures are capitalized under certain conditions, we show that the positive R&D-returns relationship weakens as an R&D project approaches completion, a finding that is consistent with Berk, Green, and Naik's (2004) risk-based theoretical prediction. This decrease in returns following progress toward R&D completion is fully explained by conventional risk factors, a finding that is inconsistent with mispricing of R&D. Furthermore, both the expensed and capitalized portions of R&D are positively associated with returns, suggesting that conservative accounting treatments cannot explain the anomaly. The results suggest overall that the R&D-to-market anomaly is attributable to compensation for bearing risk.