Contraction Options : Implications for the Profitability-Return Relation and Momentum Profits

We develop a firm valuation model with repeated expansion and contraction options to show operating profitability is a proxy for time-varying systematic risk. Relative to riskier assets, the proportionate value of contraction options increase as profitability falls, lowering the firm beta. Consistent with the predictions, operating profitability relates positively to stock betas and stock returns, and momentum strategies yield higher returns if constructed from past winners and losers with diverging operating profitability. Corroborating a risk-based explanation, the momentum results remain unexplained by, among other things, empirical measures for information diffusion, information uncertainty, credit risk and financial distress