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

Many investors cannot use leverage or short selling. According to the leverage-aversion explanation, what does this constraint imply for the low-risk anomaly and for how an unconstrained investor could exploit it?

Leverage-constrained investors overweight high-beta stocks to reach return targets, making them overpriced and low-beta stocks relatively cheap. An investor who can borrow can lever up low-beta stocks, possibly short high-beta ones, and earn a higher risk-adjusted return.

  1. AConstrained investors bid up high-beta stocks for extra return, so an unconstrained investor can lever low-beta stocksCorrect
  2. BConstrained investors overpay for low-beta stocks, so unconstrained investors should short them
  3. CThe anomaly disappears because constraints do not affect prices
  4. DUnconstrained investors should buy high-beta stocks and hold cash

Explanation

Investors unable to lever buy high-beta stocks to raise expected return, pushing their prices up and future returns down; low-beta stocks become relatively cheap. An investor able to lever can buy low-beta assets with leverage to earn higher risk-adjusted returns. The other options reverse or deny this logic.

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