Essays in investment

This dissertation consists of three essays. The first essay deals with the capital budgeting decision under uncertainty. The second is an empirical investigation of systematic volatility in stock returns on option prices. The third essay considers whether equity option prices incorporate a price of volatility risk.; The first essay, Information Arrival and Real Investment, deals with the impact of the nature of the information arrival process on the capital budgeting decision. I ask the following question: Suppose all projects have sunk costs and can be postponed or abandoned, then what determines the behavior of the hurdle rate? I show that it depends upon the nature of the information arrival process. Here, I distinguish two types of uncertainty: (1) exogenous, when the information arrival is independent of the firm's action, and (2) endogenous, when the information arrival is dependent on the firm's actions. Specifically, I show analytically that when information evolves endogenously the hurdles rate is less than that normally implied by traditional analysis, and that it decreases as uncertainty increases. The results contrast the conclusions of the prior literature on real options in investment that allow for exogenous information arrival. In particular, I show that sunk costs play a secondary role as compared with the information arrival process.; In the second essay, Systematic Volatility in Stock Return, I examine time variation in individual stock variances over the period 1932-91. I investigate the validity of a market model for variance in the presence of time-varying idiosyncratic variance. The results suggest that stock volatilities move together more than might be ordinarily implied by a linear factor model with time varying idiosyncratic variance. I show, first, that the systematic factor in variance is more fundamental than the market variance itself and second, that the mean reversion in the individual stock variance is related to the mean reversion in the market variance.; In the third essay, The Price of Volatility Risk, I investigate whether equity option prices incorporate preference parameters in the form of a price of volatility risk. If volatility is stochastic, equity options may not be solely priced by arbitrage and it is important to understand the biases induced by a market price of volatility risk. Using OEX option data, I show that option prices seem to incorporate a negative price of systematic volatility risk. The magnitude of the price of volatility risk is sufficient to make the option price significantly greater than the theoretical Black-Scholes. The results suggest that market participants are willing to pay for being long volatility.