The CAPM assumes that the only risk that an investor is concerned with is uncertainty about the future price of a security. Investors, however, are usually concerned with other risks that will affect their ability to consume goods and services in the future. Three examples would be the risks associated with future labor income, the future relative prices of consumer goods, and future investment opportunities.
Recognizing these other risks that investors face, in 1976 Robert Merton extended the CAPM based on consumers deriving their optimal lifetime consumption when they face these "extra-market" sources of risk.20 These extra-market sources of risk are also referred to as "factors," hence the model derived by Merton is called a multifactor CAPM.
The multifactor CAPM says that investors want to be compensated for the risk associated with each source of extra-market risk, in addition to market risk. In the case of the CAPM, investors hedge the uncertainty associated with future security prices by diversifying. This is done by holding the market portfolio. In the multifactor CAPM, in addition to investing in the market portfolio, investors will also allocate funds to something equivalent to a mutual fund that hedges a particular extramarket risk. While not all investors are concerned with the same sources of extra-market risk, those that are concerned with a specific extra-market risk will basically hedge them in the same way.
19 Richard R. Roll, "A Critique of the Asset Pricing Theory's Tests," Journal of Financial Economics (March 1977), pp. 129-176.
20 Robert C. Merton, "An Intertemporal Capital Asset Pricing Model," Econometri-ca (September 1973), pp. 867-888.
The multifactor CAPM is an attractive model because it recognizes nonmarket risks. The pricing of an asset by the marketplace, then, must reflect risk premiums to compensate for these extra-market risks. Unfortunately, it may be difficult to identify all the extra-market risks and to value each of these risks empirically. Furthermore, when these risks are taken together, the multifactor CAPM begins to resemble the arbitrage pricing theory model described next.
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