Underdiversification puzzle, volatility puzzle and equity premium puzzle: a common solution

Abstract

Purpose The purpose of this paper is to use some of the contributions of the option pricing theory to solve three outstanding puzzles in finance: the underdiversification puzzle, the volatility puzzle and the equity premium puzzle. Design/methodology/approach To approach the issue, this paper considers the applications of the option pricing theory to both sides of the corporate balance sheet. Applications to the left-hand side of the balance sheet has led to the real options theory that has expressed the value of a capital budgeting project as the sum of the values of its “discounted cash flow (DCF) method” and “real options.” This paper argues that, because the balance sheet must balance, the value of equity, which appears on the right-hand side of the balance sheet, should also be expressed as the sum of the values of its “DCF method” and “equity options.” Findings This proposed model of equity valuation solves the three outstanding puzzles in finance: the underdiversification puzzle, the volatility puzzle and the equity premium puzzle. Research limitations/implications This study may not be able to explain the full extent of the three puzzles. Practical implications The dividend discount model of equity valuation needs to be augmented by an option component. Social implications The community of finance scholars will become more confident of their scholarly work because three puzzles will be solved to a great extent. Originality/value To the best of author’s knowledge, the extant literature does not either solve any single one of the three puzzles through the contributions of option pricing theory or solve all three puzzles at the same time with a single solution. The originality of this paper is that it makes both of these contributions to the extant literature.