Question

You are considering a marginal investment in a small company, XYZ. You hold a very well diversified portfolio of large cap US stocks. The expected return on XYZ is 28%, the expected return on the market is 20%. XYZ has a beta of 1.3, a standard deviation of 0.35, and a residual standard deviation of 0.15. The riskless rate is 2%.

What is XYZ’s alpha? State your answer with two digits after the decimal. For example, 4.55 represents 4.55%.

For self-study, consider a concern with using alpha as a measure of performance as your investment in XYZ increases (no response required).

What performance measure might be better to use for performance if XYZ were to represent a larger share of your overall portfolio? Choices here include Sharpe Ratio, Jensen's Alpha, Treynor Ratio, or Information Ratio.

Answer 1

Calculating the expected return of XYZ using CAPM, we get r(f)+Beta(r(m)-r(f) = 2%+1.3(20%-2%)=25.4%. Alpha is a measure of excess returns of the porfolio compared to its model benchmark. So, alpha here is 28%-25.4%=2.6%.

There is a concern using alpha as a performance measure. Analysis should not be done basis on the returns alone. We need to take into consideration the risk associated in generating thise returns as well. Alpha just considers the excesa returns generated and nothing regarding the risk. That is the main concern. The other ratios like Treynor, sharp and Jensen ratios combines regurn with risk and gives a comprehensive analysis. So, these ratios will be better performance measures than Alpha.