CFA Level IPortfolio ManagementMedium
A portfolio generated an annual return of 14%. The portfolio has a beta of 1.2, the risk-free rate is 3%, and the market return during the period was 11%. Using the CAPM-derived required return as the benchmark, calculate the portfolio's Jensen's alpha.
- A2.0%
- B3.4%
- C0.8%
- D1.4%
Show answer & explanationAnswer & explanation
Correct answer: D. 1.4%
Required return = Rf + β(Rm − Rf) = 3% + 1.2 × (11% − 3%) = 3% + 9.6% = 12.6%. Jensen's alpha = Actual return − Required return = 14% − 12.6% = 1.4%. A positive alpha indicates the portfolio outperformed its CAPM-predicted return on a risk-adjusted basis.
Why the other options are wrong
- A. Incorrectly subtracts the risk-free rate twice.
- B. Uses beta incorrectly multiplied against total market return rather than the risk premium.
- C. Results from an arithmetic error in computing the risk premium.
Jensen's Alpha
Jensen's alpha measures a portfolio's risk-adjusted excess return relative to the return predicted by CAPM, given its beta.
- Alpha = Actual return − [Rf + β(Rm − Rf)]
- Positive alpha = outperformance vs. CAPM benchmark
- Requires knowing beta, risk-free rate, and market return
Memory trick: Alpha = Actual minus what CAPM said you deserved.