Hello, welcome back. Now we look at another metric. This is known as alpha. Now this is called Jensen's alpha after the person who formulated it, that is Michael Jensen. Jensen's alpha is used to determine the abnormal return of a security over the theoretical expected return. It was first used in 1968 by Michael Jensen to evaluate the performance of the mutual fund managers.

Jensen's alpha is based on the concept that risky assets should have a higher expected returns than less risky asset. Now we look at the formula for calculating Jensen's alpha. Jensen's alpha is based on the capital asset pricing models cap M and the formula is alpha is equal to ra that is return on the asset minus RF that is the risk free rate plus beta of the asset into The risk premium from the market RM minus RF RM is the return from the market. Now if we rearrange the formula, we get alpha is equal to ra minus RF minus beta into RM minus RF. Now RM minus RF is actually the excess return over the risk free rate of the asset. So we also call this as the risk premium of the asset.

Similarly, RM minus RF is the risk premium of the market or we also we call it as market risk premium. So we can rewrite the formula as alpha is equal to delta r minus beta into delta, where delta r is the asset risk premium and delta M is the market risk premium. For a layman higher the value of alpha, the higher the chances of getting more returns from a particular mutual fund. Thank you for listening. See you in the next lecture.