Because of arbitrage, any given ﬁnancial asset will be expected to return to the Security Market
Line.

Question

Quizplus · Accepted Answer

Arbitrage is the process of taking advantage of price differences in different markets to make a profit. In the context of finance, if a financial asset is overpriced relative to its expected return, investors will buy other assets with similar risk profiles that offer higher expected returns, driving down the price of the overpriced asset and pushing its expected return back to the level of the Security Market Line. Similarly, if a financial asset is underpriced relative to its expected return, investors will sell other assets with similar risk profiles that offer lower expected returns, driving up the price of the underpriced asset and pushing its expected return back to the level of the Security Market Line. This process helps to ensure that financial assets are priced efficiently and in line with their expected risk and return characteristics, resulting in a return to the Security Market Line over time.

Because of Arbitrage, Any Given ﬁNancial Asset Will Be Expected