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

Which statement best describes why the low-risk anomaly can be a source of alpha relative to CAPM?

The low-risk anomaly is that low-beta stocks have earned positive CAPM alpha while high-beta stocks have earned negative alpha, implying a flatter security market line than CAPM predicts. Leverage constraints and preference for lottery-like payoffs are common explanations.

  1. AHigh-beta stocks have historically delivered returns proportional to their beta, so low-beta stocks have negative alpha
  2. BLow-beta stocks have historically earned positive CAPM alpha and high-beta stocks negative alpha, a flatter security market line than CAPM predictsCorrect
  3. CLow-volatility stocks always outperform in rising markets
  4. DLeverage-constrained investors undervalue high-beta stocks, causing them to earn higher alpha

Explanation

Empirically the security market line is flatter than CAPM implies. Low-beta assets plot above it (positive alpha) and high-beta assets below it. A common explanation is that leverage-constrained investors bid up high-beta assets.

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