9409824 Jagannathan A substantial part of the research effort in finance is directed toward improving our understanding of how investors value risky cash flows. It is generally agreed that investors demand a higher expected return for investing in riskier projects, or securities. However, we still do not fully understand how investors assess the risk of a project's cash flow and how they determine what risk premium to demand. The contribution of this grant comes from a reassessment of the Capital Asset Pricing Model (CAPM), the framework used most often by financial managers to assess the risk of the cash flow from a project and the preferred model for classroom use in MBA and other managerial finance courses. The empirical evidence accumulated over the past two decades on the CAPM is weak, but CAPM continues to be used because the empirical support for other asset pricing models is also weak and the theoretical underpinnings of CAPM are better than those for alternative models. The investigator builds on his previous theoretical and empirical research on CAPM. Specifically, the investigator shows that by relaxing unreasonable auxiliary assumptions usually made in empirical studies of CAPM and by taking the return to human capital into account in measuring the return to aggregate wealth, he is able to obtain surprisingly strong empirical support for CAPM. In this research the investigator will use standard tests of asset pricing models with time varying parameters and develop some new statistical tests and examine their small sample properties.
