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

Which of the following is a limitation on arbitrage that helps explain why the low-risk anomaly is not eliminated by sophisticated investors?

Arbitrage is limited because exploiting the anomaly needs leverage and short selling of high-risk stocks, which are costly and constrained, and the strategy can lose heavily in rallies. These frictions keep arbitrage capital from fully correcting the mispricing.

  1. AExploiting it requires leverage or shorting high-risk stocks, which are costly and constrained, and the strategy can suffer sharp drawdowns in market ralliesCorrect
  2. BThe anomaly is entirely explained by lower transaction costs on low-beta stocks
  3. CLow-beta stocks cannot be purchased by institutional investors
  4. DHigh-beta stocks always have lower idiosyncratic volatility, so no mispricing exists

Explanation

Capturing the anomaly typically needs leverage on low-beta stocks and shorts of high-beta stocks, with financing and borrowing costs, margin and capital constraints, and risk of losses in strong rallies. These frictions limit arbitrage capital. The other statements are untrue.

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