Explanation
Jensen's alpha measures the abnormal return of a portfolio relative to its expected return based on the Capital Asset Pricing Model (CAPM). The formula for Jensen's alpha is:
Ξ±=Rpββ[Rfβ+Ξ²pβΓ(RmββRfβ)]
Where:
- Rpβ = Portfolio expected return = 8%
- Rfβ = Risk-free rate = 5%
- Ξ²pβ = Portfolio beta = 0.5
- Rmβ = Market expected return = 10%
Calculation:
Ξ±=8%β[5%+0.5Γ(10%β5%)]
Ξ±=8%β[5%+0.5Γ5%]
Ξ±=8%β[5%+2.5%]
Ξ±=8%β7.5%
Ξ±=0.5%
Therefore, Jensen's alpha for portfolio A is 0.5%, which corresponds to option A.
Key Points:
- Jensen's alpha represents the excess return earned by the portfolio manager beyond what would be expected given the portfolio's systematic risk
- A positive alpha indicates superior performance relative to the market
- The volatility information (20% for portfolio, 25% for market) is not needed for calculating Jensen's alpha