The Effects and Value of Financial Information Under a Power Utility CAPM

Abstract

Using a distribution-free "payoffs" CAPM derived under power utility, we examine the parameters of the payoff distribution that have greatest effect on the market equilibrium price, cost of capital and investor welfare. Results are necessarily all numerical, and are obtained by simulating from lognormal and normal payoff distributions. Those distributions are calibrated to approximate the empirical probability distribution of returns and payoffs on the S&P500. The overriding result is that the benefits to investors of better information arise most strongly via better estimates of the mean payoff. Estimation risk surrounding the payoff risk or variance prove surprisingly much less important. That result under our CRRA CAPM replicates similar results in finance under the conventional CARA mean-variance CAPM. We also confirm the inherent disconnection under equilibrium between the market cost of capital and investor welfare.

Keywords: CRRA CAPM, power utility, cost of capital, decision relevance, accounting information theory

JEL Classification: G11, G12, G31