MULTIFACTOR MODELS DO NOT EXPLAIN DEVIATIONS FROM THE CAPM

A number of studies have presented evidence rejecting the validity of the Sharpe-Lintner capital asset pricing model (CAPM). Possible altern atives include risk-based models, such as multifactor asset pricing mo dels, or nonrisk-based models which address biases in empirical method ology, the existence of market frictions, or the presence of irrationa l investors. Distinguishing between the alternatives is important for applications such as cost of capital estimation. This paper develops a framework which shows that, ex ante, CAPM deviations due to missing r isk factors will be very difficult to detect empirically, whereas devi ations resulting from nonrisk-based sources are easily detectable. The results suggest that multifactor pricing models alone do not entirely resolve CAPM deviations.