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FRM Part II · FRM Exam Part II · Alpha (and the Low-Risk Anomaly)

An investor wishes to exploit the low-risk anomaly but faces constraints such as a prohibition on leverage. According to the leverage-aversion explanation for the anomaly, which statement best describes the resulting opportunity?

Leverage-constrained investors overpay for high-beta stocks to boost returns, flattening the security market line. Low-beta stocks are therefore relatively cheap, and an investor able to lever them can earn a premium. The other statements reverse the pricing pressure or deny that constraints matter.

  1. AConstrained investors bid up high-beta stocks to gain extra return, so an unconstrained investor can earn a premium by holding low-beta assets and levering themCorrect
  2. BConstrained investors bid up low-beta stocks, so an unconstrained investor should short low-beta stocks
  3. CLeverage constraints should have no effect on the pricing of high-beta and low-beta stocks
  4. DConstrained investors sell high-beta stocks, so the security market line is steeper than CAPM predicts

Explanation

Investors who cannot use leverage reach for return by overweighting high-beta stocks, pushing their prices up and expected returns down. This flattens the security market line. An investor able to lever low-beta assets can capture the higher risk-adjusted return. The other options reverse the direction or deny the effect.

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