Electronic copy available at: http://ssrn.com/abstract=959950 Value Premium and ICAPM: Some Theory and Evidence Wachindra Bandara ∗ , Robert Savickas †‡ This draft: March 18, 2013 First draft: December 1, 2006 JEL classifications: G12 Keywords: ICAPM, asset productivity, value premium, growth stocks, firm volatility, noise. 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 re- garding the value premium and stock volatility suggested in prior empirical literature and provides and empirically tests some new implications. Among the new results we present are that (1) the book-to-market ratio is inversely related to the expected profitability of assets in place and to the expected market returns, (2) the value premium is contempo- raneously correlated to shocks to the aggregate book-to-market ratio, (3) the usefulness * Department of Finance, School of Business, George Washington University, 501R Funger Hall; 2201 G. St., NW, Washington, DC 20052 e mail: wbandara@gwmail.gwu.edu † Corresponding author. Department of Finance, School of Business, George Washing- ton University, 501R Funger Hall; 2201 G. St., NW, Washington, DC 20052, tel. (202)– 994–8936, fax (202)–994–5014 , e mail: savickas@gwu.edu ‡ The authors thank John Campbell, Hui Guo, Po–Hsuan “Paul” Hsu, Alexandre Bap- tista, Gergana Jostova, Marcel Rindisbacher, participants at the September 2007 con- ference of the Northern Finance Association in Toronto, September 2007 Stephen Smith Memorial Finance Conference at the Atlanta Fed, July 2007 Asian Finance Association’s meeting in Hong Kong, participants of the Washington Area Finance Association’s 14th conference at the George Mason University, and seminar participants at the George Wash- ington University for useful comments. The support received through the George Wash- ington School of Business J. Wendell and Louise Crain Fellowship and through the George Washington University Facilitating Fund Award, both awarded for Summer 2006, is grate- fully acknowledged. Older drafts of this paper were circulated under the titles “Escalat- ing Expectations, Firm Volatility, and Value Premium”, “Escalating Expectations, Value Premium, and Merton’s ICAPM”, “The Value Premium and Firm Volatility in Merton’s ICAPM” and “Value Premium, ICAPM and Firm-Level Effects”. 1