Jensen’s alpha

Definition

Jensen's alpha is a risk-adjusted performance measure that represents the average return of a portfolio or investment above what would be predicted by the Capital Asset Pricing Model (CAPM), given the portfolio’s beta and the market’s excess return. It is used to determine if an investment manager has added value through their stock-picking skills.

5 Must Know Facts For Your Next Test

1. Jensen's alpha is calculated as the actual return of the portfolio minus the expected return predicted by CAPM.
2. A positive Jensen's alpha indicates that a portfolio has outperformed its benchmark, while a negative value suggests underperformance.
3. It accounts for both systematic risk (market risk) and unsystematic risk (specific to individual investments).
4. Jensen's alpha is commonly used in performance measurement to evaluate mutual fund managers and investment strategies.
5. The formula for Jensen's alpha is Alpha = Rp - [Rf + Beta * (Rm - Rf)], where Rp is the portfolio return, Rf is the risk-free rate, Beta is the portfolio beta, and Rm is the market return.

Review Questions

• How does Jensen's alpha account for both systematic and unsystematic risk?
• What does a positive Jensen's alpha signify about an investment manager’s performance?
• What is the formula for calculating Jensen’s alpha?

Related terms

Beta: A measure of an investment's volatility compared to the market as a whole.

Capital Asset Pricing Model (CAPM): A model that describes the relationship between systematic risk and expected return for assets.

Sharpe Ratio: A measure of risk-adjusted performance calculated as the ratio of excess return over standard deviation.