The Value Premium and Firm Volatility in Merton's ICAPM

Abstract:     
Several authors have addressed the possibility that within the context of Merton's ICAPM, the value premium might proxy for the variation in investment opportunities. We provide a simple but fairly general theoretical model that produces many of the implications regarding the value premium and stock volatility suggested in prior empirical literature and provides some new implications. It is shown that the book-to-market ratio is inversely related to the expected profitability of assets in place and to the expected market returns. Our model begins with the basic definitions of stock prices, book-to-market ratios, growth, and expected market returns, imposes some mild stability requirements on financial markets, and employs the Intertemporal Asset Pricing Theory of Merton [33, 1990] to obtain the implications.

Keywords: ICAPM, asset productivity, value premium, growth stocks, firm volatility

JEL Classifications: G12

Working Paper Series