Tests of Capital Market Theory and Implications of the Evidence

Abstract

This paper will review the empirical evidence on the market model and discuss its implications for security analysis. To begin this discussion, let me point out that the Market Model, or what Sharpe (1963) originally called the diagonal model, and the Capital Asset Pricing Model are very distinct models. Neither one depends in any way on the other. Many people confuse these two models but they refer to quite different concepts and it is well to keep the distinction clearly in mind. This paper will consider the major characteristics of the Market Model, provide some illustrative examples and briefly summarize the evidence. A Technical Paper prepared in connection with this paper considers the major characteristics of the Asset Pricing Model and a discussion of the theoretical and empirical content of the Two Factor Model.

Keywords: market model, capital market theory, capital asset pricing model, market returns, two factor model, market returns, diversification, market forecasts, risk