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We show that corporate investment decisions can explain the conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and the current product market demand. Book-to-market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data. CORPORATE INVESTMENT DECISIONS are often evaluated in a real options context, 1 and option exercise can change the riskiness of a firm in various ways. For example, if growth opportunities are finite, the decision to invest changes the ratio of growth options to assets in place. Additionally, the resulting increase in physical capital may generate operating leverage through long-term obligations, including the fixed operating costs of a larger plant, wage contracts, and commitments to suppliers. It is natural to conclude that expected returns might be related to current and historical investment decisions of the firm.The empirical literature has long recognized a need to account for the dynamic structure of risk when testing asset pricing models. 2 A small but growing literature that endogenizes expected returns through firm-level

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