Question

# Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?

Solution

Verified

The CAPM shows the connection between market risk and expected rate of return. It also takes into account the expected return, risk free rate and beta. If a small firm's stock is not traded as much that means there is a small number of shares being moved and the stock is then illiquid. When that happens usually the price of shares is lower and a bit harder to sell fast. The positive CAPM in this case can mean that the investors are adjusting the risk levels because of how hard it is selling shares of illiquid stock that aren't at a discount rate. This is not a violation of efficient market hypothesis because there is an increased percentage of risk associated with positive CAPM alpha.

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