Could anyone explain to me what alpha is and how it relates to the Capital Asset Pricing Model and different values in the CAPM. Im on the brink of understanding it, but i just need someone to explain it differently than my book.
2007-12-15 14:52:25 · 4 answers · asked by Anonymous in Business & Finance ➔ Investing
You have a portfolio. It has a required risk premium attached to it. The risk premium is the amount of returns you require for taking the investment risk. Alpha is the amount by which the portfolio outperforms or underperforms the required rate of return, otherwise known as risk premium.
Say you're required rate of return based on the portfolio's risk profile is 10%. If you made 15%, then your alpha would be 5%. If you made 7%, then your alpha would be -3%.
It's basically measuring the excess returns or losses from the amount of risk invested in.
It was hard for me to understand at first too, but it'll click, trust me...
2007-12-15 15:15:09 · answer #1 · answered by trancevanbuuren 3 · 0⤊ 1⤋
Alpha is the excess return earned that cannot be accounted for by market risk. It is sometimes thought of as money earned by skill.
However, the intercept, whose formula is a=Y-bX, is the dumping ground for all kinds of things. If you have misspecified the model and the CAPM is a misspecified model, then the alpha term includes not only excess return, but all other errors in the model, presuming the model is in expectations unbiased and consistant.
So, if the bX term is the accounting for market risk, the a term is the leftovers. It is the sum of all unaccounted for things.
Going back to the basic definitions of regression, the true line in a two variable problem is Y=bX, however, since it is estimated with errors, the model is Y=bX+e, where e is error. In expectations e=0, but in implementation a includes part of that term.
2007-12-16 10:09:58 · answer #2 · answered by OPM 7 · 0⤊ 0⤋
Alpha is simply the excess return above your portfolio's benchmark which includes the risk-free rate + the risk premium. Portfolio managers and others try to achieve alpha by beating the market which is typically the S&P500 Index. If your risk-free rate is 5% and your risk-premium required is 4% then your required return is at-least 9%. If the S&P500 stock index performed at 9% for the year and your actual portfolio returned 11% then you managed to obtain an alpha of 2%. Keep in mind the text book likes to leave out these management fees and other fees so alpha may be reduced a bit. Hopefully this helps.
2007-12-16 02:38:05 · answer #3 · answered by part_swapper 2 · 0⤊ 0⤋
http://www.investopedia.com/terms/a/alpha.asp
2007-12-15 23:05:58 · answer #4 · answered by jeff410 7 · 0⤊ 0⤋