Alpha represents the excess return earned by an investment compared to its benchmark index, adjusted for risk. It measures how well an investment strategy, portfolio manager, or trader has performed in relation to the broader market. A positive alpha indicates the investment has outperformed the benchmark, while a negative alpha suggests underperformance. Alpha is considered a key metric to evaluate the skill of active portfolio managers.

Alpha = Actual Return − Expected Return

Expected Return=Risk-Free Rate+β×(Benchmark Return−Risk-Free Rate)

Expected Return:

  • Definition: The return that an investor anticipates or expects to earn from an investment over a given period.
  • Significance: This is the target return that helps investors decide if an investment aligns with their financial goals and risk tolerance.

Risk-Free Rate:

  • Definition: The return on an investment that is considered free of risk, often represented by the yield on government bonds like Indian 10 year government bonds.
  • Significance: This rate serves as a baseline for measuring the risk of other investments. It's assumed that the risk-free rate can be earned without taking on any risk.

Beta (β):

  • Definition: A measure of an investment's volatility or systematic risk relative to the overall market.
  • Significance: Beta indicates how much an investment's returns are expected to move in relation to the market's returns.
    • β = 1: The investment's returns are expected to move in line with the market.
    • β > 1: The investment is more volatile than the market.
    • β < 1: The investment is less volatile than the market.
    • β < 0: The investment moves inversely to the market.

Benchmark Return (Market Return):

  • Definition: The return of a broad market index (e.g., Nifty50) that serves as a benchmark for the performance of the investment.
  • Significance: The benchmark return represents the average return of the market, which is used to compare and evaluate the performance of individual investments.