Question

state and explain how CAPM has been extended to allow for additional determination of excess returns

Answer 1

Excess return is also known as Jenson’s alpha. Excess return represents the efficiency of a fund manager to generate the return which is higher than expected return based on capital asset pricing model equation (CAPM). Fund managers are rated on basis of excess return they generate. Excess return is based on equation which is difference of generated return by fund manager and CAPM equation.

The below equations will bring more clarity to above discussion:

Excess return is represented by equation;

Excess return or alpha = Rp – Ri

Where, Ri = Rf + Beta of Ri x (Rm – Rf) …….. [Ri is worked out through CAPM equation]

Rp = Return on portfolio of fund manager ; Ri = Expected return on other portfolio, Rf = Risk free rate, Rm = Market Return

If Rp is positive then it is concluded that portfolio manager is outperforming the other fund managers.