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

Behavioral explanations of the low-risk anomaly often cite a preference for lottery-like payoffs. Which statement correctly applies this idea?

Investors with a lottery preference overpay for positively skewed, jackpot-like stocks, which are typically high-volatility names. The resulting overpricing lowers their expected returns, leaving low-volatility stocks with higher risk-adjusted returns, which is a behavioral explanation of the low-risk anomaly.

  1. AInvestors overpay for stocks with positively skewed, jackpot-like returns, which tend to be high-volatility stocks, lowering their expected returnsCorrect
  2. BInvestors dislike positive skewness and so sell high-volatility stocks, raising their expected returns
  3. CLottery preferences cause investors to prefer stable dividend payers, raising their prices and lowering their volatility
  4. DLottery preferences affect only bond markets, not equities

Explanation

Preference for lottery-like payoffs leads investors to overpay for high-volatility, positively skewed stocks, so these deliver lower subsequent returns than risk would warrant. Option B reverses the preference, and the others are unsupported.

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