Refer to the graph. Each labeled point represents a different asset. For which of these assets would we not expect arbitrage to change the average expected rate of return?
A) E only
B) D, E, and F
C) E, G, and H
D) D, E, F, G, and H

Question

Refer to the graph. Each labeled point represents a different asset. For which of these assets would we not expect arbitrage to change the average expected rate of return?
A) E only 
B) D, E, and F 
C) E, G, and H 
D) D, E, F, G, and H

Quizplus · Accepted Answer

In order for an arbitrage opportunity to exist, there must be a discrepancy in the prices of the assets that can be exploited to generate a riskless profit. If such an opportunity arises, market participants will buy the underpriced asset and sell the overpriced asset, which will drive the prices towards an equilibrium and eliminate the arbitrage opportunity. This process will change the expected rates of return for the affected assets. 
Based on the graph, asset E has the same expected return as asset D and a lower standard deviation, which makes it a more desirable investment. Therefore, market participants will buy more of asset E and sell more of asset D, which will drive up the price of E and drive down the price of D, changing their expected returns. 
On the other hand, assets G and H have the same expected returns and standard deviations as assets A and B, respectively. Therefore, there is no arbitrage opportunity between these assets and their counterparts, and their expected returns should not change due to arbitrage. Therefore, the correct answer is C, as we would not expect arbitrage to change the average expected rate of return for assets E, G, and H.

Refer to the Graph