Jensen's alpha

From Wikipedia, the free encyclopedia

In finance, Jensen's alpha (or Jensen's Performance Index) is used to determine the excess return of a stock, other security, or portfolio over the security's required rate of return as determined by the Capital Asset Pricing Model. This model is used to adjust for the level of beta risk, so that riskier securities are expected to have higher returns. The measure was first used in the evaluation of mutual fund managers by Michael Jensen in the 1970's.

To calculate alpha, the following inputs are needed:

• the realized return (on the portfolio),
• the market return,
• the risk-free rate of return, and
• the beta of the portfolio.

Jensen's alpha = Portfolio Return - (Risk free return + (Market Return - Risk free Return) * Beta)

Alpha is still widely used to evaluate mutual fund and portfolio manager performance, often in conjunction with the Sharpe ratio and the Treynor ratio.