Question

You find an asset that does not lie on the security market line (SML). Is there an arbitrage opportunity? Briefly explain, with reference to Arbitrage Pricing Theory.

Answer 1

There is an arbitrage opportunity when we consider CAPM i.e., sensitivity of stock returns to only market returns but when we consider Arbitrage Pricing Theory, it might be possible that the security's returns can not be modelled appropriately using just market sensitivity and there might be some factors which need to be considered and hence when those factors are considered it may so happen that expected returns is appropriate hence there is no arbitrage opportunity.