Question

According to the theory of arbitrage:

a. High-beta stocks are consistently overpriced.

b. Low-beta stocks are consistently overpriced.

c. Positive alpha investment opportunities will quickly disappear.

d. Rational investors will pursue arbitrage consistent with their risk tolerance.

Short answer

The Correct answer is ‘c.’

Step-by-step solution

Definition

The Arbitrary Pricing Theory predicts the assets’ returns using the linear relationship between the assets expected returns and a number of other variables.

Explanation of the theory

The Arbitrage Pricing Theory estimates the return on an asset by using the relation between asset and common risk factors of other assets. According to this theory, since alpha is the excess return un-affected by any risk factors, it is much sought after by investors leading to the driving up the price of high alpha stocks (thereby reducing the expected return) until they quickly disappear. Hence the correct option from the above statement would be option ‘c’.