Alpha

The Alpha Alphabet

2012-12-04 09:44:12
Marc Odo
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One of the most frequently used terms in finance is “alpha”. Alpha is generally accepted as meaning “manager skill”. Certainly an important concept, it is unfortunate there are so many misconceptions about what alpha is and is not. Searching the web and old textbooks sometimes makes matters worse, as there many different definitions floating around.

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Alpha

The Alpha Alphabet by Marc Odo, CFA, CAIA, CFP

Date: 
Tue, 2012-07-17

One of the most frequently used terms in finance is “alpha”. Alpha is referenced so widely and in so many different contexts that confusion about exactly what people mean when they use it is inevitable. This paper seeks to clarify and explain what alpha is and is not, and to differentiate between all of the variations on the basic concept of such a common statistic.

Alpha

The alpha and beta of a manager vs. a benchmark are obtained by fitting a straight line to the points in a scatter plot of the market returns vs. the manager's returns. Alpha is the intercept of this straight line, while beta is the slope. Hence, if the market returns change by some amount x, then the manager returns can be expected to change by Beta * x.

Alpha is the mean of the excess return of the manager over beta times benchmark:

mean(i = 1, ... , m)( mi - Beta * bi )

Alpha is a measure of risk (beta)-adjusted return.

 
 

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