Recent studies indicate that the widespread assumption of parameter stationarity in empirical applications of asset pricing models may be inappropriate. This paper investigates the feasibility of modeling parameter instability as a sequence of persistent stable regimes. Recursive residual and log likelihood techniques are combined to detect and locate shift points. The results indicate that regime shifts are widespread, frequent, and often large enough to significantly effect empirical findings. The nature of the shifts appears to be a rotation of the regression line, indicating that correction of both alpha and beta parameters is required.

The concept of a relationship between assumed risk and realized return is intuitively pleasing and has become widely accepted in the field of finance. Until recently this acceptance was anchored largely in what Hirschleifer [11] has called the “notorious fact” that stocks yield more in the long run than bonds and Hickman's finding [10] (since challenged by Fraine [7]) that over the years 1900–1943 the average ex post yield on publicly issued corporate debt was higher the lower the initial quality rating. However, with the advent of the capital asset pricing model of Sharpe [21], Lintner [16], and Mossin [19] the risk-return tradeoff concept has grown in importance and scope. The capital asset pricing model itself has weathered the years well, but has been theoretically and empirically revised, extended, and otherwise altered. Little remains of the original formulation except the proposition that in equilibrium more risk leads to more return--where “risk” for common stocks now means the nondiversified component as measured by the “Beta” coefficient of return volatility vis-à-vis the general market. As Modigliani and Pogue [18] observe after a review of the “more important” empirical tests of the capital asset pricing model: “Obviously, we cannot claim that the CAPM is absolutely right. On the other hand, the empirical tests do support the view that beta is a useful risk measure and that high beta stocks tend to be priced so as to yield correspondingly high rates of return.”