Eugene F. Fama and Kenneth R. French, "Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance 51 (1996), pp. 55-84. III. Equilibrium In Capital Markets 10. Single−Index and Multifactor Models The McGraw−Hill Companies, 2001           312 PART III Equilibrium in Capital Markets     factors, these variables may proxy for yet-unknown more fundamental variables. For ex- ample, Fama and French point out that firms with high ratios of book-to-market value are more likely to be in financial distress and that small firms may be more sensitive to changes in business conditions. Thus these variables may capture sensitivity to risk factors in the macroeconomy.     Theoretical Foundations of Multifactor Models   The CAPM presupposes that the only relevant source of risk arises from variations in stock returns, and therefore a representative (market) portfolio can capture this entire risk. As a result, individual-stock risk can be defined by the contribution to overall portfolio risk; hence the risk premium on an individual stock is determined solely by its beta on the mar- ket portfolio. But is this narrow view of risk warranted? Consider a relatively young investor whose future wealth is determined in large part by labor income. The stream of future labor income is also risky and may be intimately tied to the fortunes of the company for which the investor works. Such an investor might choose an investment portfolio that will help to diversify labor-income risk. For that purpose, stocks with lower-than-average correlation with future labor income would be favored, that is, such stocks will receive higher weights in the individual portfolio than their weights in the market portfolio. Put another way, using this broader notion of risk, these investors no longer consider the market portfolio as efficient and the rationale for the CAPM expected return-beta relationship no longer applies. In principle, the CAPM may still hold if the hedging demands of various investors are equally distributed across different types of securities so that deviations of portfolio weights from those of the market portfolio are offsetting. But if hedging demands are common to many investors, the prices of securities with desirable hedging characteristics will be bid up and the