It also considers the volatility of a particular security in relation to the market. The term alpha refers to the index used in many financial models, say the CAPM ( capital asset pricing model Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk.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.Next, the actual rate of return achieved by the portfolio is calculated based on its current value and the previous value.Expected rate of return of portfolio = Risk-free rate of return + β * (Market return – Risk-free rate of return) 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.Next, the beta of a portfolio is determined by assessing the movement of the portfolio compared to the benchmark index.Market risk premium = Market return – Risk rate of return Consequently, the market risk premium is computed by deducting the risk-free rate of return from the market return. 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.

read more of government security, say Treasury bonds, over a substantial period. This return provides details about the compounded return earned yearly and compares the returns supplied by various investments like stocks, bonds, derivatives, mutual funds, etc. Firstly, figure out the risk-free rate, which can be determined from the average annual return Annual Return The annual return is the income generated on an investment during a year as a percentage of the capital invested and is calculated using the geometric average.read more, and then deducting the result from the actual rate of return of the portfolio. read more, a beta of the portfolio, and market risk premium Market Risk Premium The 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. Although, it does not exist because every investment has a certain amount of risk. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. 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 return Risk-free Rate Of Return A risk-free rate is the minimum rate of return expected on investment with zero risks by the investor.

Formula to Calculate Alpha of a PortfolioĪlpha 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.

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