Alpha (finance)

Alpha is a measure of the so-called active return on an investment, the performance of that
investment compared to a suitable market index. An alpha of 1 means the investment's return on
investment over a selected period of time was 1% better than the market during that same
period, an alpha of -1 means the investment underperformed the market. Alpha is one of the five
key measures in modern portfolio theory.
In modern financial markets, where index funds are widely available for purchase, alpha is
commonly used to judge the performance of mutual funds and similar investments. As these
funds include various fees normally expressed in percent terms, the fund has to maintain an
alpha greater than its fees in order to provide positive gains compared to an index fund.
Historically, the vast majority of traditional funds have had negative alphas, which has led to
a flight of capital to index funds and non-traditional hedge funds.
It is also possible to analyze a portfolio of investments and calculate a theoretical performance,
most commonly using thecapital asset pricing model (CAPM). Returns on that portfolio can be
compared to the theoretical returns, in which case the measure is known as Jensen's alpha. This
is useful for non-traditional or highly focused funds, where a single stock index might not be
representative of the investment's holdings.

Definition[edit]
The alpha coefficient ( ) is a parameter in the capital asset pricing model (CAPM). It is
the intercept of the security characteristic line (SCL), that is, the coefficient of the constant in a
market model regression.

It can be shown that in an efficient market, the expected value of the alpha coefficient is
zero. Therefore the alpha coefficient indicates how an investment has performed after
accounting for the risk it involved:

: the investment has earned too little for its risk (or, was too risky for the return)

: the investment has earned a return adequate for the risk taken

: the investment has a return in excess of the reward for the assumed risk

For instance, although a return of 20% may appear good, the investment can still have a
negative alpha if it's involved in an excessively risky position.

Origin of the concept

A belief in efficient markets spawned the creation of market capitalization weighted index
funds that seek to replicate the performance of investing in an entire market in the weights
that each of the equity securities comprises in the overall market. [citation needed] The best examples
for the US are the S&P 500 and the Wilshire 5000 which approximately represent the 500
most widely held equities and the largest 5000 securities respectively, accounting for
approximately 80%+ and 99%+ of the total market capitalization of the US market as a
whole.
In fact, to many investors,[citation needed] this phenomenon created a new standard of performance
that must be matched: an investment manager should not only avoid losing money for the
client and should make a certain amount of money, but in fact should make more money
than the passive strategy of investing in everything equally (since this strategy appeared to
be statistically more likely to be successful than the strategy of any one investment

manager). The name for the additional return above the expected return of the beta adjusted
return of the market is called "Alpha".

Relation to beta
Besides an investment manager simply making more money than a passive strategy, there is
another issue: although the strategy of investing in every stock appeared to perform better
than 75 percent of investment managers, the price of the stock market as a
whole fluctuates up and down, and could be on a downward decline for many years before
returning to its previous price.
The passive strategy appeared to generate the market-beating return over periods of 10
years or more. This strategy may be risky for those who feel they might need to withdraw
their money before a 10-year holding period, for example. Thus investment managers who
employ a strategy which is less likely to lose money in a particular year are often chosen by
those investors who feel that they might need to withdraw their money sooner.
Investors can use both alpha and beta to judge a manager's performance. If the manager
has had a high alpha, but also a high beta, investors might not find that acceptable, because
of the chance they might have to withdraw their money when the investment is doing poorly.
These concepts not only apply to investment managers, but to any kind of investment.

Beta (finance)
In finance, the beta () of an investment is a measure of the risk arising from exposure to
general market movements as opposed to idiosyncratic factors. The market portfolio of all
investable assets has a beta of exactly 1. A beta below 1 can indicate either an investment with
lower volatility than the market, or a volatile investment whose price movements are not
highly correlated with the market. An example of the first is a treasury bill: the price does not go
up or down a lot, so it has a low beta. An example of the second is gold. The price of gold does
go up and down a lot, but not in the same direction or at the same time as the market. [1]
A beta greater than one generally means that the asset both is volatile and tends to move up and
down with the market. An example is a stock in a big technology company. Negative betas are
possible for investments that tend to go down when the market goes up, and vice versa. There
are few fundamental investments with consistent and significant negative betas, but
some derivatives like equity put options can have large negative betas.[2]
Beta is important because it measures the risk of an investment that cannot be reduced
by diversification. It does not measure the risk of an investment held on a stand-alone basis, but
the amount of risk the investment adds to an already-diversified portfolio. In the capital asset
pricing model, beta risk is the only kind of risk for which investors should receive an expected
return higher than the risk-free rate of interest.[3]
The definition above covers only theoretical beta. The term is used in many related ways in
finance. For example, the betas commonly quoted in mutual fund analyses generally measure
the risk of the fund arising from exposure to a benchmark for the fund, rather than from exposure
to the entire market portfolio. Thus they measure the amount of risk the fund adds to a diversified
portfolio of funds of the same type, rather than to a portfolio diversified among all fund types. [4]
Beta decay refers to the tendency for a company with a high beta coefficient ( > 1) to have its
beta coefficient decline to the market beta. It is an example of regression toward the mean.

Statistical estimation[edit]
Beta is estimated by regression. Given an asset and a benchmark that we are interested in, we
want to find an approximate formula

where ra is the return of the asset and rb is return of the benchmark.

Since the data are usually in the form of time series, the statistical model is
,

where t is an error term (the unexplained return). Click here for a definition of Alpha ().
The best (in the sense of least squared error) estimates for and are those such that t2 is as
small as possible.
A common expression for beta is

,
where Cov and Var are the covariance and variance operators.
This can also be expressed as

where a,b is the correlation of the two returns, and a and b are the respective volatilities.
Relationships between standard deviation, variance and

correlation:
Beta can be computed for prices in the past, where the data is known, which is historical beta.
However, what most people are interested in is future beta, which relates to risks going forward.
Estimating future beta is a difficult problem. One guess is that future beta equals historical beta.
From this, we find that beta can be explained as "correlated relative volatility".
This has three components:

correlated

relative

volatility

Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred
to as a measure of the sensitivity of the asset's returns to market returns, its nondiversifiable risk, its systematic risk, or market risk. On an individual asset level, measuring beta
can give clues to volatility and liquidity in the marketplace. In fund management, measuring beta
is thought to separate a manager's skill from his or her willingness to take risk.
The portfolio of interest in the CAPM formulation is the market portfolio that contains all risky
assets, and so the rb terms in the formula are replaced by rm, the rate of return of the market. The
regression line is then called the security characteristic line (SCL).

is called the asset's alpha and

is called the asset's beta coefficient. Both coefficients
have an important role inmodern portfolio theory.
For example, in a year where the broad market or benchmark index returns 25% above the risk
free rate, suppose two managers gain 50% above the risk free rate. Because this higher return is
theoretically possible merely by taking aleveraged position in the broad market to double the
beta so it is exactly 2.0, we would expect a skilled portfolio manager to have built the
outperforming portfolio with a beta somewhat less than 2, such that the excess return not
explained by the beta is positive. If one of the managers' portfolios has an average beta of 3.0,
and the other's has a beta of only 1.5, then the CAPM simply states that the extra return of the
first manager is not sufficient to compensate us for that manager's risk, whereas the second
manager has done more than expected given the risk. Whether investors can expect the second
manager to duplicate that performance in future periods is of course a different question.

Security market line[edit]

The Security Market Line

The SML graphs the results from the capital asset pricing model (CAPM) formula. Thex-axis
represents the risk (beta), and the y-axis represents the expected return. The market risk
premium is determined from the slope of the SML.
The relationship between and required return is plotted on the security market line(SML) which
shows expected return as a function of . The intercept is the nominal risk-free rate available for
the market, while the slope is E(Rm) Rf. The security market line can be regarded as
representing a single-factor model of the asset price, where Beta is exposure to changes in value
of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable
expected return for risk. Individual securities are plotted on the SML graph. If the security's risk
versus expected return is plotted above the SML, it is undervalued because the investor can

expect a greater return for the inherent risk. A security plotted below the SML is overvalued
because the investor would be accepting a lower return for the amount of risk assumed.

Choice of benchmark[edit]
In the U.S., published betas typically use a stock market index such as the S&P 500 as a
benchmark. The S&P 500 is a popular index of U.S. large-cap stocks. Other choices may be an
international index such as the MSCI EAFE. The benchmark is often chosen to be similar to the
assets chosen by the investor. For example, for a person who owns S&P 500 index funds and
gold bars, the index would combine the S&P 500 and the price of gold. In practice a standard
index is used.
The choice of the index need not reflect the portfolio under question; e.g., beta for gold bars
compared to the S&P 500 may be low or negative carrying the information that gold does not
track stocks and may provide a mechanism for reducing risk. The restriction to stocks as a
benchmark is somewhat arbitrary. A model portfolio may be stocks plus bonds. Sometimes the
market is defined as "all investable assets" (see Roll's critique); unfortunately, this includes lots of
things for which returns may be hard to measure.

Investing[edit]
By definition, the market itself has a beta of 1.0, and individual stocks are ranked according to
how much they deviate from the macro market (for simplicity purposes, the S&P 500 is
sometimes used as a proxy for the market as a whole). A stock whose returns vary more than the
market's returns over time can have a beta whose absolute value is greater than 1.0 (whether it
is, in fact, greater than 0 will depend on the correlation of the stock's returns and the market's
returns). A stock whose returns vary less than the market's returns has a beta with an absolute
value less than 1.0.
A stock with a beta of 2 has returns that change, on average, by twice the magnitude of the
overall market's returns; when the market's return falls or rises by 3%, the stock's return will fall
or rise (respectively) by 6% on average. (However, because beta also depends on the correlation
of returns, there can be considerable variance about that average; the higher the correlation, the
less variance; the lower the correlation, the higher the variance.) Beta can also be negative,
meaning the stock's returns tend to move in the opposite direction of the market's returns. A
stock with a beta of 3 would see its return decline 9% (on average) when the market's return
goes up 3%, and would see its return climb 9% (on average) if the market's return falls by 3%.
Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for
higher returns. Lower-beta stocks pose less risk but generally offer lower returns. Some have
challenged this idea, claiming that the data show little relation between beta and potential
reward, or even that lower-beta stocks are both less risky and more profitable (contradicting
CAPM).[5] In the same way a stock's beta shows its relation to market shifts, it is also an indicator
for requiredreturns on investment (ROI). Given a risk-free rate of 2%, for example, if the market
(with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should return 11%
(= 2% + 1.5(8% 2%)) in accordance with the financial CAPM model.

Adding to a portfolio[edit]
Suppose an investor has all his money in an asset class X and wishes to move a small amount
to an asset class Y. For example, X could be U.S. stocks, while Y could be stocks of a different
country, or bonds. Then the new portfolio, Z, can be expressed symbolically

The variance can be computed as

which can be simplified by ignoring 2 terms:

The first formula is exact, while the second one is only valid for small . Using the formula for
of Y relative to X,

we can compute

This suggests that an asset with greater than one will increase variance, while an asset with
less than one will decrease variance, if added in the right amount. This assumes that variance is
an accurate measure of risk, which is usually good. However, the beta does need to be
computed with respect to what the investor currently owns.

Academic theory[edit]
Academic theory claims that higher-risk investments should have higher returns over the longterm. Wall Street has a saying that "higher return requires higher risk", not that a risky investment
will automatically do better. Some things may just be poor investments (e.g., playing roulette).
Further, highly rational investors should consider correlated volatility (beta) instead of simple
volatility (sigma). Theoretically, a negative beta equity is possible; for example, an inverse
ETF should have negative beta to the relevant index. Also, a short position should have opposite
beta.
This expected return on equity, or equivalently, a firm's cost of equity, can be estimated using
the capital asset pricing model (CAPM). According to the model, the expected return on equity is
a function of a firm's equity beta (E) which, in turn, is a function of both leverage and asset risk
(A):

where:
KE = firm's cost of equity
RF = risk-free rate (the rate of return on a "risk free investment"; e.g., U.S. Treasury Bonds)
RM = return on the market portfolio

because:

and
Firm value (V) + cash and risk-free securities = debt value (D) + equity value (E)
An indication of the systematic riskiness attaching to the returns on ordinary shares. It equates to
the asset Beta for an ungeared firm, or is adjusted upwards to reflect the extra riskiness of
shares in a geared firm., i.e. the Geared Beta.[6]

Multiple beta model[edit]

The arbitrage pricing theory (APT) has multiple betas in its model. In contrast to the CAPM that
has only one risk factor, namely the overall market, APT has multiple risk factors. Each risk factor
has a corresponding beta indicating the responsiveness of the asset being priced to that risk
factor.
Multiple-factor models contradict CAPM by claiming that some other factors can influence return,
therefore one may find two stocks (or funds) with equal beta, but one may be a better
investment.

Estimation of beta[edit]
To estimate beta, one needs a list of returns for the asset and returns for the index; these returns
can be daily, weekly or any period. Then one uses standard formulas from linear regression. The
slope of the fitted line from the linear least-squares calculation is the estimated Beta. The yintercept is the alpha.
Myron Scholes and Joseph Williams (1977) provided a model for estimating betas from
nonsynchronous data.[7]
Beta specifically gives the volatility ratio multiplied by the correlation of the plotted data. To take
an extreme example, something may have a beta of zero even though it is highly volatile,
provided it is uncorrelated with the market. Tofallis (2008) provides a discussion of this, [8] together

with a real example involving AT&T Inc. The graph showing monthly returns from AT&T is visibly
more volatile than the index and yet the standard estimate of beta for this is less than one.
The relative volatility ratio described above is actually known as Total Beta (at least by appraisers
who practice business valuation). Total beta is equal to the identity: beta/R or the standard
deviation of the stock/standard deviation of the market (note: the relative volatility). Total beta
captures the security's risk as a stand-alone asset (because the correlation coefficient, R, has
been removed from beta), rather than part of a well-diversified portfolio. Because appraisers
frequently value closely held companies as stand-alone assets, total beta is gaining acceptance
in the business valuation industry. Appraisers can now use total beta in the following equation:
total cost of equity (TCOE) = risk-free rate + total betaequity risk premium. Once appraisers
have a number of TCOE benchmarks, they can compare/contrast the risk factors present in
these publicly traded benchmarks and the risks in their closely held company to better
defend/support their valuations.

Interpretations of Beta
Some interpretations of beta are explained in the following table:[9]

Value
of
Beta

Interpretation

Example

<0

Asset generally moves in the

opposite direction as compared
to the index

An inverse exchange-traded fund or a

short position

=0

Movement of the asset is

uncorrelated with the movement
of the benchmark

Fixed-yield asset, whose growth is

unrelated to the movement of the
stock market

0<
<1

Movement of the asset is

generally in the same direction
as, but less than the movement
of the benchmark

Stable, "staple" stock such as a

company that makes soap. Moves in
the same direction as the market at
large, but less susceptible to day-today fluctuation.

=1

Movement of the asset is

generally in the same direction
as, and about the same amount
as the movement of the
benchmark

A representative stock, or a stock that

is a strong contributor to the index
itself.

>1

Movement of the asset is

generally in the same direction
as, but more than the movement
of the benchmark

Stocks which are very strongly

influenced by day-to-day market news,
or by the general health of the
economy.

It measures the part of the asset's statistical variance that cannot be removed by
the diversification provided by the portfolio of many risky assets, because of the correlation of its
returns with the returns of the other assets that are in the portfolio. Beta can be estimated for
individual companies using regression analysis against a stock market index. An alternative to
standard beta is downside beta.
Beta is always measured in respect to some benchmark. Therefore, an asset may have different
betas depending on which benchmark is used. Just a number is useless if the benchmark is not
known.

Extreme and interesting cases

Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile
stocks.

Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds and cash.
However, simply because a beta is zero does not mean that it is risk-free. A beta can be zero
simply because the correlation between that item's returns and the market's returns is zero. An
example would be betting on horse racing. The correlation with the market will be zero, but it is
certainly not a risk-free endeavor.
On the other hand, if a stock has a moderately low but positive correlation with the market, but a
high volatility, then its beta may still be high.
A negative beta simply means that the stock is inversely correlated with the market.
A negative beta might occur even when both the benchmark index and the stock under
consideration have positive returns. It is possible that lower positive returns of the index coincide
with higher positive returns of the stock, or vice versa. The slope of the regression line in such a
case will be negative.
Using beta as a measure of relative risk has its own limitations. Most analyses consider only the
magnitude of beta. Beta is a statistical variable and should be considered with its statistical
significance (R square value of the regression line). Higher R square value implies
higher correlation and a stronger relationship between returns of the asset and benchmark index.
If beta is a result of regression of one stock against the market where it is quoted, betas from
different countries are not comparable.
Utility stocks commonly show up as examples of low beta. These have some similarity to bonds,
in that they tend to pay consistent dividends, and their prospects are not strongly dependent on
economic cycles. They are still stocks, so the market price will be affected by overall stock
market trends, even if this does not make sense.
Staple stocks are thought to be less affected by cycles and usually have lower beta. Procter &
Gamble, which makes soap, is a classic example. Other similar ones are Philip Morris (tobacco)
and Johnson & Johnson (Health & Consumer Goods).
'Tech' stocks are commonly equated with higher beta. This is based on experience of the dotcom bubble around year 2000. Although tech did very well in the late 1990s, it also fell sharply in
the early 2000s, much worse than the decline of the overall market. More recently, this is not a
good example.
During the 2008 market fall, finance stocks did very poorly, much worse than the overall market.
Then in the following years they gained the most, although not to make up for their losses. They
are still higher beta.
Foreign stocks may provide some diversification. World benchmarks such as S&P Global
100 have slightly lower betas than comparable US-only benchmarks such as S&P 100. However,
this effect is not as good as it used to be; the various markets are now fairly correlated,
especially the US and Western Europe.[citation needed]
Derivatives and other non-linear assets. Beta relies on a linear model. An out of the money
option may have a distinctly non-linear payoff. The change in price of an option relative to the
change in the price of the underlying asset (for example a stock) is not constant. For example, if
one purchased a put option on the S&P 500, the beta would vary as the price of the underlying
index (and indeed as volatility, time to expiration and other factors) changed. (see options pricing,
and BlackScholes model).

Criticism[edit]

Seth Klarman of the Baupost group wrote in Margin of Safety: "I find it preposterous that a single
number reflecting past price fluctuations could be thought to completely describe the risk in a
security. Beta views risk solely from the perspective of market prices, failing to take into
consideration specific business fundamentals or economic developments. The price level is also
ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the
same IBM at 100 dollars per share. Beta fails to allow for the influence that investors themselves
can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder
resolutions, communications with management, or the ultimate purchase of sufficient stock to
gain corporate control and with it direct access to underlying value. Beta also assumes that the
upside potential and downside risk of any investment are essentially equal, being simply a
function of that investment's volatility compared with that of the market as a whole. This too is
inconsistent with the world as we know it. The reality is that past security price volatility does not
reliably predict future investment performance (or even future volatility) and therefore is a poor
measure of risk."[10]
At the industry level, beta tends to underestimate downside beta two-thirds of the time (resulting
in value overestimation) and overestimate upside beta one-third of the time resulting in value
underestimation.[11]
Another weakness of beta can be illustrated through an easy example by considering two
hypothetical stocks, A and B. The returns on A, B and the market follow the probability
distribution below:

Probability

Market

Stock A

Stock B

0.25

30%

15%

60%

0.25

15%

7.5%

30%

0.25

15%

30%

7.5%

0.25

30%

60%

15%

The table shows that stock A goes down half as much as the market when the market goes down
and up twice as much as the market when the market goes up. Stock B, on the other hand, goes
down twice as much as the market when the market goes down and up half as much as the
market when the market goes up. Most investors would label stock B as more risky. In fact, stock
A has better return in every possible case. However, according to the capital asset pricing model,
stock A and B would have the same beta, meaning that theoretically, investors would require the
same rate of return for both stocks. This is an illustration of how using standard beta might
mislead investors. The dual-beta model, in contrast, takes into account this issue and
differentiates downside beta from upside beta, or downside risk from upside risk, and thus allows
investors to make better informed investing decisions.

In finance, delta neutral describes a portfolio of related financial securities, in which the portfolio
value remains unchanged when small changes occur in the value of the underlying security.
Such a portfolio typically contains options and their corresponding underlying securities such that
positive and negative delta components offset, resulting in the portfolio's value being relatively
insensitive to changes in the value of the underlying security.
A related term, delta hedging is the process of setting or keeping the delta of a portfolio as close
to zero as possible. In practice, maintaining a zero delta is very complex because there are risks
associated with re-hedging on large movements in the underlying stock's price, and research
indicates portfolios tend to have lower cash flows if re-hedged too frequently.[1]
Contents
[hide]

1Nomenclature

2Mathematical interpretation

3Creating the position

4Theory

5References

6External links

Nomenclature[edit]
The sensitivity of an option's value to a change in the underlying stock's price.
The initial value of the option.
The current value of the option.
The initial value of the underlying stock.

Mathematical interpretation[edit]
Main article: Greeks (finance)

Delta measures the sensitivity of the value of an option to changes in the price of the underlying
stock assuming all other variables remain unchanged.[2]
Mathematically, delta is represented as partial derivative

of the option's fair value with respect

to the price of theunderlying security.

Delta is clearly a function of S, however Delta is also a function of strike price and time to
expiry. [3]
Therefore, if a position is delta neutral (or, instantaneously delta-hedged) its instantaneous
change in value, for aninfinitesimal change in the value of the underlying security, will be zero;
see Hedge (finance). Since delta measures the exposure of a derivative to changes in the value
of the underlying, a portfolio that is delta neutral is effectively hedged. That is, its overall value
will not change for small changes in the price of its underlying instrument.

Creating the position[edit]

Delta hedging - i.e. establishing the required hedge - may be accomplished by buying or selling
an amount of the underlier that corresponds to the delta of the portfolio. By adjusting the amount
bought or sold on new positions, the portfolio delta can be made to sum to zero, and the portfolio
is then delta neutral. See Rational pricing #Delta hedging.
Options market makers, or others, may form a delta neutral portfolio using related options
instead of the underlying. The portfolio's delta (assuming the same underlier) is then the sum of
all the individual options' deltas. This method can also be used when the underlier is difficult to
trade, for instance when an underlying stock is hard to borrow and therefore cannot be sold
short.
One example of delta neutral strategy is buying a deep in the money call and buying a deep in
the money put option. Deep in the money call will have delta of 1 and deep in the money put will
have delta of -1. Hence their deltas will cancel each other to some extent of stock price
movement.

Theory[edit]
The existence of a delta neutral portfolio was shown as part of the original proof of the Black
Scholes model, the first comprehensive model to produce correct prices for some classes of
options. See Black-Scholes: Derivation.
From the Taylor expansion of the value of an option, we get the change in the value of an
option,

, for a change in the value of the underlier

where

(delta) and

(gamma); see Greeks (finance).

For any small change in the underlier, we can ignore the second-order term and use the
quantity

to determine how much of the underlier to buy or sell to create a hedged

portfolio. However, when the change in the value of the underlier is not small, the
second-order term,

, cannot be ignored: see Convexity (finance).

In practice, maintaining a delta neutral portfolio requires continuous recalculation of the

position's Greeks and rebalancing of the underlier's position. Typically, this rebalancing is
performed daily or weekly.