Question

A zero-investment well-diversified portfolio with a positive alpha could arise if:

a. The expected return of the portfolio equals zero.

b. The capital market line is tangent to the opportunity set.

c. The law of one price remains un-violated.

d. A risk-free arbitrage opportunity exists.

Short answer

The Correct answer is ‘d’

Step-by-step solution

Definition

A set of financial portfolios composed of securities that result in cumulatively a net value of zero is known as zero-investment portfolio.

Evaluation of the theory of arbitrage

The risk-free arbitrage opportunity implies buying a stock at a lower price and selling it simultaneously at a higher price, thereby gaining by the difference without having any holding period. In such cases, the investor either invests nothing (i.e. zero investment) or receives an initial inflow but expects a positive payoff (i.e. positive alpha). Since such situations arise when there exists risk-free arbitrage opportunity, the correct answer would be an option ‘d’.