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Jensen’s Alpha
A fundamental interpretation of Jensen’s alpha shows a stocks performance over time
compared to its expected return. The most common model used to predict theoretical stock
yield for Jensen’s alpha is the Capital Market Pricing Model (CAPM) which takes into
account the stock’s risk by looking at its past volatility compared to the market as a whole.
Jensen’s alpha is calculated by subtracting the predicted yield of a stock (obtained from
CAPM) from the actual yield. Therefore, a positive alpha value represents a stock that
outperformed it’s predicted performance, a negative alpha represents a stock that
underperformed its predicted performance, and an alpha of zero would mean that the
selected stock performed exactly as predicted. CAPM predicts the performance of a stock
(Stock i) by subtracting the risk free rate (Rf) from the expected market (Rm) return and
multiplying by beta of stock i (βi), then adding that to the risk free rate (Rf).
E(Ri) = Rf + βi( E(Rm) - Rf )
This means that how a how the market is expected to perform to the risk free rate can then
be multiplied by beta (a measure of risk, but it also shows how a stock’s price moves
historically compared to the market) and then added back to the risk free rate to obtain to
obtain a decent model for the return on that stock or portfolio. Another way to think about
it is the right half of the equation represents the premium paid to investors over the risk
free rate in proportion to the risk of that certain investment. If this is subtracted from the
