Prices for State-Contingent Claims: Some Estimates and Applications

In this paper, we present an approach to investment decisions under uncertainty that we hope will interest both business managers seeking to improve the efficiency of internal capital budgeting procedures and economists seeking insights to the behavior of aggregate business investment. Twenty years ago, a paper with such objectives would have been squarely within the mainstream of research in the field of finance. For a variety of reasons, however, the attention given to problems of applied capital budgeting in the serious literature has fallen substantially in recent years. In part, this dwindling of interest reflects the emergence in the middle 1960s of exciting new topic areas with great research potential, such as the capital asset pricing model (hereafter CAPM) of Sharpe-Lintner, the efficient markets doctrine, and, more recently, the theory of rational option pricing. But, in part, it reflects the judgment of the profession that the benefit/cost ratio of further research on applied capital budgeting was turning unfavorable. Such was particularly the case for research focusing on the cost of capiThis paper presents a method for making risk adjustments in practical capital budgeting applications that has advantages over the currently available alternatives. The method relies on estimates of the implicit in the market portfolio to compute the net present value of the expected payoffs of a proposed project. Tables of such state prices are presented, obtained by applying the BlackScholes option pricing formula to the Ibbotson-Sinquefield predictive distribution of real returns. The paper concludes with some cautions and suggestions for further research.