IN A RECENT PAPER in the American Economic Review [6], we presented empirical evidence that the relationship between rate of return and risk implied by the market-line theory is unable to explain differential returns in the stock market. As a result, the risk-adjusted measures of portfolio performance based on this theory yield seriously biased estimates of portfolio performance.' We advanced but did not test several tenable reasons for these observed biases, which included the inability of investors to borrow large amounts of money at the same risk-free interest rate at which they can lend, and deficiencies in the return generating models which are required to translate ex ante expected returns and "risks" into ex post realizations. Recent papers by Fischer Black [1] and Stephen Ross [11] present theoretical models which suggest that the breakdown of the borrowing and lending mechanism would be expected to bias these measures, but not for the explicit reasons we gave. The purpose of this paper is to examine both theoretically and empirically in greater depth than was done previously the reasons why the market-line theory does not adequately explain differential returns on financial assets. The first section of the paper briefly reviews the salient points of the marketline theory as recently modified and analyzes the implications of the theory. The second section estimates several types of risk-return tradeoffs implied by stocks on the New York Stock Exchange for three different periods after World War II and shows that the empirical results cast serious doubt on the validity of the market-line theory in either its original form or as recently modified. On the other hand, these results do confirm the linearity of the relationship for NYSE stocks. The third section suggests that the market for NYSE stocks is segmented from the bond market unless the return generating process is different from any heretofore tested. This has important implications for both the measurement of portfolio performance and the determination of optimal corporate financing.