Alpha Formula

Formula to Calculate Alpha of a Portfolio

Alpha is an index which is used for determining the highest possible return with respect to the least amount of the risk and according to the formula, alpha is calculated by subtracting the risk-free rate of the return from the market return and multiplying the resultant with the systematic risk of the portfolio represented by the beta and further subtracting the resultant along with the risk-free rate of the return from the expected Rate of the return on the portfolio.

The formula for calculation of alpha can be done first by calculating the expected rate of return of the portfolio based on the risk-free rate of returnRisk-free Rate Of ReturnA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more, a beta of the portfolio, and market risk premiumMarket Risk PremiumThe market risk premium is the supplementary return on the portfolio because of the additional risk involved in the portfolio; essentially, the market risk premium is the premium return investors should have to make sure to invest in stock instead of risk-free securities.read more, and then deducting the result from the actual rate of return of the portfolio.

Alpha of portfolio = Actual rate of return of portfolio – Expected Rate of Return on Portfolio

or

Alpha of portfolio = Actual rate of return of portfolio – Risk-free rate of return – β * (Market return – Risk-free rate of return)

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For eg:
Source: Alpha Formula (wallstreetmojo.com)

Alpha of a Portfolio Calculation (Step by Step)

  1. Firstly, figure out the risk-free rate, which can be determined from the average annual return of government security, say Treasury bonds, over a substantial period.

  2. Next, figure out the market return, which can be done by tracking the average annual return of a benchmark index, say S&P500, over a substantial period. Consequently, the market risk premium is computed by deducting the risk-free rate of return from the market return. Market risk premium = Market return – Risk rate of return

  3. Next, the beta of a portfolio is determined by assessing the movement of the portfolio compared to the benchmark index.

  4. Now, based on the risk-free rate of return (step 1), a beta of the portfolio (step 3), and market risk premium (step 2), the expected rate of return of the portfolio is calculated as below. Expected rate of return of portfolio = Risk-free rate of return + β * (Market return – Risk-free rate of return)

  5. Next, the actual rate of return achieved by the portfolio is calculated based on its current value and the previous value.

  6. Finally, the formula for calculation of alpha of the portfolio is done by deducting the expected rate of return of the portfolio (step 4) from the actual rate of return of the portfolio (step 5) as above.

Examples

You can download this Alpha Formula Excel Template here – Alpha Formula Excel Template

Let us take the example of a mutual fundMutual FundA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more that has realized a return of 16% during the last year. The appropriate benchmark index for the fund has a book annual return of 11%. Further, the beta of the mutual fund vis-à-vis that benchmark index is 1.3while the risk-free rate of return is 4%. Do the calculation of the alpha of the mutual fund.

As per the question, the following is the data for the calculation of the alpha formula.

alpha formula example 1.1

Expected Rate of Return

Expected rate of return = Risk-free rate of return + β * (Benchmark return – Risk-free rate of return)

alpha formula example 1.2
  • = 4% + 1.3 * (11% – 4%)
  • = 13.1%

Therefore, Calculation of Alpha of the mutual fund will be as follows –

example 1.3
  • Alpha of the mutual fund = Actual rate of return – Expected rate of return
  • Alpha = 16% – 13.1%

Alpha Calculation of Mutual Funds

example 1.4
  • Alpha = 2.9%

The alpha of the mutual fund is 2.9%.

Relevance and Uses of Alpha Formula

Recommended Articles

This has been a guide to Alpha Formula. Here we learn how to calculate the Alpha of a Portfolio using a practical example and downloadable excel templates. You may learn more about Financial Analysis from the following articles –

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