Economics Risk And Return Questions Medium
Jensen's alpha, also known as the Jensen index or Jensen's performance measure, is a risk-adjusted performance metric used in finance to evaluate the excess return of an investment or portfolio compared to its expected return based on its level of systematic risk. It was developed by Michael Jensen, a prominent economist and finance professor.
Jensen's alpha is calculated by subtracting the expected return of an investment or portfolio, as estimated by the Capital Asset Pricing Model (CAPM), from its actual return. The CAPM is a widely used model that relates the expected return of an investment to its systematic risk, as measured by beta.
The formula for Jensen's alpha is as follows:
Jensen's alpha = Actual Return - [Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)]
In this formula, the actual return represents the realized return of the investment or portfolio, the risk-free rate is the return on a risk-free asset such as a government bond, beta is the measure of systematic risk, and the market return is the average return of the overall market.
A positive Jensen's alpha indicates that the investment or portfolio has outperformed its expected return, while a negative alpha suggests underperformance. It is a useful tool for assessing the skill of fund managers or evaluating the performance of investment strategies, as it takes into account both the risk and return aspects of an investment.