Jensen's Alpha

This video shows how to calculate Jensen's Alpha.

Jensen's Alpha is the portion of the excess return (of a security or a portfolio) that is not explained by systematic risk. Thus, alpha is a risk-adjusted measure of return.

Another way of explaining it is that Jensen's Alpha is the difference between the actual return (of a security or a portfolio) and the return predicted by the Capital Asset Pricing Model.

Jensen's Alpha is calculated as follows:

Alpha = [return of security or portfolio - risk-free rate] - [beta * (market return - risk-free rate)]

For example, let's say that the actual return of a security is 26%, the actual return of the market is 12%, the risk-free rate is 2%, and the beta of the security is 2.00. In this case, alpha would be 4%. This was calculated as follows:
alpha = [26% - 2%] - [2* (12% - 2%)] = 4%

Another way of thinking about it is this: according to the Capital Asset Pricing Model, this security was expected to have a return of 22%. Yet, it had an actual return of 26%. This difference between the expected return (according to CAPM) and the actual return is the alpha. It is the portion of the excess return that is not explained by systematic risk (beta).—
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