Short-term real options are more sensitive to aggregate shocks than long-term real options because they are closer to being exercised and converted to assets-in-place, and thus have a larger real option delta. Consequently, equities with embedded short-term real options are riskier and earn higher returns on average than do equities with embedded long-term real options. This mechanism is stronger the more real options are embedded, for example, for growth firms. I show empirically that the average returns of short duration growth stocks with embedded short-term real options are significantly higher than the average returns of long-duration growth stocks with embedded long-term real options, that is, the term structure of returns for growth stocks is downward sloping. Moreover, systematic risk, as measured by cash-flow betas, also exhibits a downward sloping term structure for growth firms. In contrast, both long- and short-duration value stocks possess little real options, and hence their return (and cash-flow beta) difference is not significantly different from zero; the term structure of returns for value stocks is flat. A two-factor model, with cash flow and discount rate, captures the cross-sectional variation of returns across stocks sorted by duration and the book-to-market ratio.

Keywords: Real options theory, Cross-section of stock returns, Term structure of equity