To have an understanding of Alpha, an understanding of the concept of Stock Beta is important.
The Beta of a stock is the measure of non-diversifiable risk that the stock incorporates. It is calculated as follows: Beta = Cov (jm) / σ 2m
Where, Cov(jm) = Covariance between the daily return of the individual security and the daily return of the market (Eg. Nifty)
and σ 2m = Variance of the daily market return.
A stock with a Beta value greater than 1 is generally considered to be a high beta stock. Since the high beta stock is riskier than than the market, an investor would expect a return over and above the market return – as a premium for the additional risk undertaken by him.
The expected return from a stock can be calculated using the Capital Asset Pricing Model (CAPM)
as follows : r(j) = rf + β (rm – rf)
Where, rf– Risk free rate of return (inter-bank rates)
β – Beta of stock bench-marked to the market index
rm –Return of Benchmark Index
For example, If a stock has a beta value of 1.5. The market return is 12% and the inter-bank rate is 4%. The return expected from the stock is as follows:
r(j) = 4 + 1.5 (12 – 4)
r(j) = 16%
Now that we’ve had a fair understanding of the concept of Beta, we move on to the concept of Alpha.
Alpha measures whether the actual returns generated by a stock have been able to match the returns mandated by CAPM . Note that the concept of Beta is fundamental to the computation of Alpha.
Therefore Alpha = Actual Return – Return required by CAPM
Continuing with the previous example if the stock has generated a return of 17% over the past one year, we can say that the stock has a positive alpha value.
A stock with a positive Alpha can be interpreted to have generated better than expected results for its investors. On the other hand returns from stocks with a negative alpha have not been able to generate return commensurate with the risks assumed by an investor of such stocks.
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