The Foundations and Current State of Capital Market Theory

Abstract

This essay reviews the development of modern capital market theory (i.e., general equilibrium models of the prices of capital assets under conditions of uncertainty) and the empirical evidence bearing on this theory. There are two main approaches to this problem; the mean-variance models following in the Markowitz (1952; 1959) tradition, and the state preference models due originally to Arrow (1953) and Debreu (1959). Both approaches are generalizations to a world of uncertainty of the work of Irving Fisher (1965) on the theory of interest. The state preference approach- is more general than the mean-variance approach and provides a truly elegant framework for investigating theoretical issues, but unfortunately it has proved to be difficult to give it substantial empirical content. I shall restrict my attention here to the mean-variance models.

Section II provides a brief review of the historical foundations of capital market theory and a statement of the assumptions and implications of the Sharpe-Lintner mean-variance model of asset pricing. Section III reviews our empirical knowledge about the process determining the structure of asset prices and returns. Section IV surveys recent theoretical developments in this area and integrates (to some extent) those developments with our empirical knowledge. Section V contains the conclusions.

Keywords: mean-variance capital asset pricing model, capital market theory, equilibrium, systematic risk, riskless borrowing, riskless lending, market efficiency.