Question

If Arbitrage Pricing Theory is correct, but markets are not efficient at any level, what would you know if you estimated an alpha of 2% per year for a well-diversified portfolio? Explain.

Answer 1

The arbitrage pricing theory says that the required return on an asset can be predicted with a linear relationship between and asset and the factors that affect the risk component. The alpha is the excess return generated over the required rate after adjusting for risk of a security. If the portfolio is well diversified then the alpha is generated then that alpha will be eliminated in a efficient market as more people will be attracted towards the stock and the price of the security will increase and the return will decrease and more in line with the required rate of return however if the markets are not efficient then it can be because of the information asymmetricity and the alpha being generated is not necessary and alpha but it can be because of the underestimation of the risk factors which are affecting the required rate of returns of the stock.