Question

In an efficient market, stocks with an expected negative alpha, their alpha would _____.

A.) disappear (alpha goes to zero)

B.) become even more negative

C.) Stay as is (negative)

D.) Become positive

E.) Be investigated by the SEC for insider trading

Answer 1

In an efficient market, stocks with an expected negative alpha, their alpha would "disappear (alpha goes to zero)".

We know, alpha is term which records abnormal return i.e. difference between expected return and required return. Efficient markets are in equilibrium i.e. expected return is equal to required return indicating an alpha equal to zero, but there may be temporary periods of disequilibrium representing mispricing. The investor will trade to exploit this mis-pricing and eventually alpha will vanish and again the state of equilibrium would be restored. Therefore, Option A is the correct answer.