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Explain whether it is possible to earn excess returns without taking on additional risk.

Question:

Explain whether it is possible to earn excess returns without taking on additional risk.

What Is The Incremental Risk:

It is common for investors to assess the Incremental Risk between two alternative investments when a buying decision is required. The Incremental Risk is the additional risk taken on by the investor to earn an additional return on a given alternative investment.

Answer and Explanation:

Technically, it is possible to earn additional returns without any incremental risk even though it is rare. The most common form of this manifestation is in arbitrage.

  • Arbitrage occurs when an investor obtains a return with virtually no risk. This can be done, for instance, by trading currencies 3-way to take advantage of any pricing mismatches.
  • Although arbitrage can still occur in a liquid market, given the computerized nature of our markets it is very difficult to spot and take advantage of such opportunities nowadays.

Learn more about this topic:

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How to Reduce Investment Risks

from Finance 305: Risk Management

Chapter 3 / Lesson 8
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