Investment markets and principles
Jensen’s Alpha is used to measure the risk-adjusted performance of a security or portfolio in relation to the expected market return (which is based on the capital asset pricing model (CAPM)). The higher the alpha, the more a portfolio has earned above the level predicted.
The measure was first used by Michael Jensen in 1968 and was originally designed to evaluate FUND MANAGERS, i.e. to gauge if it was possible for them to consistently outperform the markets. Jenson’s results, however, suggested that this is rarely the case.
Jensen’s Alpha is important to investors because they need to look not only at the total return of a SECURITY or portfolio, but also at the amount of risk involved in achieving that return.
Usually, investors will aim to achieve a high return with a minimum amount of risk. So if, for example, two portfolios yielded identical returns, but one involved lower risk, the one with lower risk would rationally be the more attractive option.
Jensen’s Alpha can help determine if the average return generated is acceptable based on the amount of risk involved. If the return is higher than that predicted by the CAPM, the security or portfolio is said to have a positive alpha (or an abnormal return). Investors are always looking for opportunities where a positive alpha is involved.
Jensen’s Alpha is calculated using the following equation:
α=R_p-[R_f+β_p (R_m-R_f )]
R_p=expected portfolio return
R_f=risk free rate
β_p=beta of the portfolio
R_m=expected market return
If the estimated alpha is significantly higher than 0, it means the company outperforms the market.
Answer the following questions:
Outline and assess the CAPM model.
Download up to 5 years of monthly prices for your allocated stock and calculate the monthly return of this stock. Enter them into the Excel program (BAC5014.xlsx) and calculate the alpha of your stock. Discuss your results.
Evaluate the question “Is it possible to beat the market?” by using empirical evidence: your evidence from question (2) and evidence from literature.
Jensen, M. C. (1968). The performance of mutual funds in the period 1945–1964. The Journal of finance, 23(2), 389-416
You can download data for the question from uk.finance.yahoo.com.
(See http://www.youtube.com/watch?v=vl8_FD5EU-Y for downloading stock data from Yahoo Finance)
File BAC5014.xlsx contains an Excel program for calculating the Jensen’s alpha.
Printed copy (including excel file) to be submitted to I-ZONE by due date.