The Implications of Recursiveness in Capital Markets–Theory and Empirical Tests

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Much of the current work in the analysis of security returns has been directed towards improving the specification of the Sharpe diagonal capital market model [9]. Because the residuals from the market model for different securities are observed to be correlated, some factor or factors are assumed to be common to large groups of stocks exclusive of the economy-wide influences captured by the market index. King [6], for example, found industry effects to be a significant determinant of security returns. In recent articles in this journal and elsewhere Lee and Lloyd, hereafter (L&L) ([7] [8]) attempt to capture the interaction of firms within an industry. They propose a recursive capital market model, an approach which is attractive because it allows for interaction in the determination of stock prices without the complications of a more fully simultaneous equations model (Simkowitz and Logue [10]). However, the L&L application of the recursive system is not without problems in both theory and application.