If XYZ Corporation's common stock has the same beta as ABC Company's but produces better returns, what explains this difference?

The correct answer is that XYZ stock has a higher alpha than ABC stock.

In finance, alpha measures the performance of an investment relative to a market index or benchmark that is considered to represent the market's movement as a whole. A stock with a positive alpha indicates that it has outperformed the market after adjusting for its level of risk, which is represented by beta.

Since both XYZ Corporation and ABC Company have the same beta, it means they are affected similarly by market movements in terms of risk exposure. However, if XYZ stock has produced better returns, this suggests that it is generating excess returns beyond what would be expected based on its level of systematic risk. Therefore, the higher alpha of XYZ stock indicates superior performance relative to ABC, which is the reason for the difference in returns despite having the same beta.

Volatility in ABC stock or less demand for XYZ stock does not directly contribute to the return differential in the way that alpha does, and while higher risk could potentially lead to higher returns, it isn’t the determining factor in this scenario since beta is equal. This specific aspect of excess returns and their relationship with alpha is key in understanding this particular situation.