Next, determine the market return and usually, the return of the major stock market index is taken as the proxy for market return. Typically, the annual yield of government bonds or treasury bills are considered to be risk-free and as such is used as the risk-free rate of return. The formula for alpha can be derived by using the following steps:įirstly, determine the risk-free rate of return for the case.
Therefore, the Portfolio Manager has been Skillful enough to Generate a Portfolio Alpha of 1.35%. Portfolio Beta is calculated using the formula given below Based on the given information, determine whether the Portfolio Manager could generate any Alpha. The 10-year treasury bill currently offers a Return of 2.07%. S&P 500 is the suitable benchmark index for the Portfolio and it Realized a Return of 4.74% during the last one year. The beta of the Respective Securities are 1.2, 1.5 and 1.0 and their Weight in the Portfolio is 0.30, 0.45 and 0.25. Let us take another example of a Portfolio of three securities yielding Actual Returns of 5%, 8% and 7% during last year. Therefore, the Alpha of the Portfolio is 1%. Expected Rate of Return = 2% + 1.5 * 2%Īlpha is calculated using the formula given belowĪlpha = Actual Rate of Return – Expected Rate of Return.Market Risk Premium = Market Return – Risk-Free RateĮxpected Rate of Return is calculated using the formula given belowĮxpected Rate of Return = Risk-Free Rate + β * Market Risk Premium Market Risk Premium is calculated using the formula given below
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