Improving the Market Model: The 4-State Model Alternative

The present paper conducts an empirical study by examining the Market Model and the three versions of the 4-State Model (translated, rotated and un-rotated) in a mean-beta framework. Using daily returns from the CAC 40 Index's assets, we find that the explanatory power of the 4- State Model is greater than the one of the Market Model and this effect is improved by rotation. A reduction in the non-systematic risk is also observed when switching from Market Model to 4- State Models. Surprisingly, the betas are more stable when using any version of the 4-State Model. This could have a strong impact on portfolio diversification and call widely held opinion into question.