Alpha Coefficient

Overview of Alpha Coefficient
In the context of capital asset pricing model the alpha coefficient acts as a parameter. The alpha coefficient could also be described as the intercept of Security Characteristic Line or SCL. In case of an efficient market, the anticipated value for the alpha coefficient is equal to the return that could be obtained from an asset, which is free from risks.

This relation may be depicted through the following equational representation:

E(αi) = rf
Uses of Alpha Coefficient
The alpha coefficient is often employed in order to ascertain if a particular business entity or an investment manager has been able to generate sufficient economic value or not.

The following table provides some numerical presentations that deal with these matters:

Numerical Presentation Meaning
αi < rf The particular business entity has not been able to generate any economic value
αi > rf The company or the respective investment manager has generated economic value
αi = rf Economic value has neither been generated or diminished

Jensen’s Alpha
Jensen’s Alpha gives the difference between αi and rf
Origins of Alpha Coefficient
The Alpha Coefficient originated in the twentieth century. It was seen that almost three-fourths of the stock investment managers were earning lesser money compared to individual investors of the stock market who were either putting in an equal amount of money in all the shares or investing according to the market size of the particular stock.

According to the economists a lot of people were investing in the stock market simultaneously. This brought about a situation where at any single point of time the prices of the shares were appropriate. As a consequence of the increased efficiency of the stock market it was difficult for all the stock investment managers to achieve optimum results.

The efficient stock markets or rather the confidence of the investors about the stock market efficiency brought about index funds that were weighed by market capitalization. The most suitable examples of such funds would be Wilshire 5000 and S&P 500.

Wilshire 5000 represents 5000 of the largest securities that are traded in the securities market of the United States of America. This index accounts for almost 99 percent of the whole securities market capitalization of the United States of America.

S&P 500 stands for 500 of the largest equities traded in the United States of America equities market. It accounts for close to 80 percent of the entire US market capitalization
Effects of Alpha Coefficient
As far as the investors were concerned, the Alpha Coefficient raised the bar. Now the investment managers try to avoid making losses. They also need to make more money than the passive investors of the stock market.
Relationship with Beta Coefficient
The Alpha Coefficient as well as the Beta Coefficient is used by the investors for the purpose of measuring the business performance of an investment manager.

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Last Updated on : 1st July 2013

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