What is Jensen’s Alpha?
Jensen’s alpha also known as Jensen’s Measure was developed by Michael Jensen in 1968. It is a measure which gives the difference between person returns versus the overall market. It is used for calculation of return on a portfolio in excess to the one suggested by the capital asset pricing model (CAPM). The risk-adjusted return shows that the manager is able to extract more mileage from his investments. It is denoted by α.
Jensen’s Formula:
Jensen’s Alpha = Expected Portfolio Return – [Risk-Free Rate + Beta of the Portfolio * (Expected Market Return – Risk-Free Rate)]
α = Rp – [ Rf + β (Rm – Rf)]
Where:
α = Jensen’s Alpha
Rp = Returns of the Portfolio
Rf = Risk-free rate
β = Stock’s beta
Rm = Market return
It is usually represented in percentage format which means that we know the percent change by which our portfolio over or underperforms.
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How does this formula work?
The formula can be applied to any type of assets which may include stocks, bonds, securities, and derivatives.
The stocks beta represents an asset’s volatility wrt to the overall market factors. The beta value which is less than 1 indicates that it is less volatile compared to the benchmark index and vice versa.
The value of alpha may be positive, negative, or zero. Thus, if the actual returns are equal to the one that is predicted by the CAPM model then the alpha is 0. If the security earns is more then, alpha is positive else negative.
An Illustration:
Consider the example of ABC stock. If the return based on CAPM is 10% and the actual stock return is 15%, risk free rate is 5% and the stock beta index is 1.5
α = 15% – ( 5% + 1.5* (10% – 5%)) = 15% – 12.5% = 2.5%
The positive value shows that the mnager has compensated more than the risk which they took for the year.
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Why Is Jensen’s Measure Important?
Every investor must understand the risks they would be taking when they invest in a particular asset and they need a calculated measure of the total returns against the risk that is involved in the investment. The sole aim of investors is to go for security which offers them greater returns with minimum risk.
Thus, the scheme for which returns are high and risk is a minimum is more lucrative to the investors. Jensen’s alpha can help the investors to know if the return on asset is generating average returns in comparison to the risk involved which is known as a risk-adjusted return. So, make sure that you make a calculated risk-adjusted return these options offer in order to understand what you are getting into. Thus, higher the alpha value more lucrative the
Author: Trushali Hindocha
About the Author: Trushali completed her graduation in Computer science and engineering, she has worked as Associate Consultant in Atos Syntel for 18 months. She is currently pursuing MMS in Finance from KJ Somaiya Institute of Management Studies and Research, Mumbai. She is also well acquainted with Tableau and programming languages like Python and R for Data Analytics.
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