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Monday, May 4, 2009

Alpha (investment)

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers' performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen's alpha.

The alpha coefficient (αi) is a parameter in the capital asset pricing model (CAPM). It is the intercept of the Security Characteristic Line (SCL). Alternatively, it is also the coefficient of the constant in a market model regression.

It can be shown that in an efficient market, the expected value of the alpha coefficient equals the return of the risk free asset: Ei) = rf.

Therefore the alpha coefficient indicates how an investment has performed after accounting for the risk it involved:

  • αi < rf: the investment has earned too little for its risk (or, was too risky for the return)
  • αi = rf: the investment has earned a return adequate for the risk taken
  • αi > rf: the investment has a return in excess of the reward for the assumed risk

For instance, although a return of 20% may appear good, the investment can still have a negative alpha if it's involved in an excessively risky position.

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