The Effect of Uncertainty on Investment: Evidence from Options

There is wide debate over the impact of uncertainty on firm behavior, due to the difficulty both of measuring uncertainty and of identifying causality. This paper takes three steps that attempt to address these challenges. First, we develop an instrumental variables strategy that exploits firms’ differential exposure to energy and currency prices and volatility. For example, airlines are negatively affected by high oil prices while oil refiners benefit from them, but both are sensitive to oil price volatility; retailers, in comparison, are not particularly sensitive to either the level or volatility of oil prices. Second, we use the expected volatility of stock prices as implied by equity options to obtain forward-looking measures of uncertainty over firms’ business conditions. Finally, we examine how uncertainty affects a range of outcomes: capital investment, hiring, research and development, and advertising. We find that uncertainty depresses capital investment, hiring, and advertising, but encourages R&D spending. This perhaps-surprising result for R&D is consistent with a theoretical literature emphasizing that long investment lags create valuable real put options which offset the effects of call options lost when projects are started. Aggregating across our panel of Compustat firms, we find that rising uncertainty accounts for roughly a third of the fall in capital investment and hiring that occurred in 2008-10.