Real Options, Idiosyncratic Skewness, and Diversification

Abstract

We show how firm-level real options lead to idiosyncratic skewness in stock returns. We then document empirically that growth option variables are positive and significant determinants of idiosyncratic skewness. The real option impact on skewness is more significant in firms with lottery-type features, small size, high volatility, distressed, low return on assets, and low book-to-market ratio. We also find that expectation on idiosyncratic skewness is associated with lower Sharpe ratios. This suggests investors are willing to sacrifice mean-variance portfolio efficiency for greater skewness deriving from real options. Furthermore, financial flexibility has a positive incremental effect, enhancing the beneficial role of asset flexibility on idiosyncratic skewness.