Financial Risk Manager Part 1

Alpha is a measure of the excess return or value that has been added or subtracted by a fund manager. The alpha coefficient indicates the performance of a portfolio relative to its benchmark. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%. When we say that the alpha is statistically significant, it means that the chances of this alpha being a result of random chance (luck) are very low. Therefore, a statistically significant positive alpha indicates that the manager has consistently outperformed the market, which is a clear sign of superior market timing. The statistical significance is usually tested using the t-statistic, which is the estimated value of alpha divided by its standard deviation. A t-statistic greater than 2 is generally considered statistically significant at the 95% confidence level.

Choice A is incorrect. A zero alpha indicates that the portfolio manager has neither underperformed nor outperformed the market, implying no superior market timing skills.

Choice B is incorrect. While a positive alpha does indicate that the portfolio manager has outperformed the market, it does not necessarily signify superior market timing skills. It could be due to other factors such as stock selection or sector allocation.

Choice C is incorrect. A statistically significant negative alpha suggests that the portfolio manager has consistently underperformed compared to what would be expected given their level of systematic risk exposure, indicating poor performance rather than superior market timing skills.