|
| |
|
|
|
 |
Tutorial |
 |
 |
 |
 |
 |
| Market
Risk Exposure |
 |
|
 |
|
|
|
|
|
| |
| Goal |
To explain the concepts of
alpha, beta and R2, and to show how they can be used to analyze and
assess your portfolio's risk level.
|
| Definition |
- Alpha
– The difference in the expected return of your portfolio, given the
portfolio's beta, and the actual return the portfolio achieved. The higher
your Alpha, the better your portfolio has done in achieving
"excess" returns. It is generally considered the higher the
alpha, the higher the "value added" to the portfolio by the
portfolio manager. (Note: The market portfolio alpha is always 0.0)
-
Beta – Measures the portfolio's sensitivity to movements in
the market portfolio, or benchmark index (e.g., S&P 500 always has a Beta
of 1.0). A beta > 1.0 means that the asset or portfolio is more volatile
(risky) than the benchmark index, and a beta < 1.0 means the asset or
portfolio is less volatile.
-
R2 – Indicates the percentage of a portfolio's
movement that is explained by the movement in the market portfolio or
benchmark index. R2 ranges from 0 to 100%, with a score of 100 indicating that
all movements of the portfolio are completely explained by the market
portfolio or benchmark index. In general, the higher the R2, the more reliable
a portfolio's alpha and beta measurements will be.
|
| How it works |
- A portfolio's Beta is calculated by comparing a portfolio's volatility
to the market's volatility over time. The more sensitive a portfolio's
returns are to movements in the market, the higher the portfolio's beta
will be. Higher Betas therefore imply higher risk.
- Using a portfolio's Beta and the expected return on the market
portfolio (e.g. SP500), we can estimate a return for the portfolio. If the
actual return on the portfolio differs from the estimated return, we have
an Alpha. A positive Alpha tells us the actual return exceeded the
estimated, whereas a negative Alpha indicates the actual return did not
meet the estimated return.
- R2 helps us understand how useful the Beta and Alpha numbers are for any
given portfolio. The closer to 100%, the more meaningful our Beta and
Alpha measurements are.
|
| A Practical
Example |
The chart below illustrates the user portfolio's exposure to market risk.
A beta of 1.4 suggests that the user's portfolio is more volatile than the
S&P 500. An alpha of 7.2 tells us that the portfolio exceeded its expected
return, given the portfolio's beta. Finally, the user portfolio's R2
measurement suggests that 77% of its volatility can be explained by volatility
in the market. The user portfolio's high R2 lends credibility to its alpha and
beta measurements.
| Market
Exposure Measurement |
User Portfolio |
S&P 500 Portfolio |
| Beta |
1.4 |
1.0 |
| Alpha |
7.2 |
0 |
| R2 |
77% |
100% |
|
| Conclusion |
These measurements are a useful means of comparing your portfolio's risk level
with that of the market portfolio, or benchmark index (e.g. S&P 500).
FinPortfolio recommends using Market Risk Exposure together with Risk-Adjusted
Return and VaR in order to form a comprehensive view of your portfolio's risk.
If your are able to maintain a portfolio with a low beta, a high alpha and a
high R-squared, you are a doing well. Such a portfolio is achieving a better
return than its level of market risk suggests it should.
|
| Relevant Links |
|
|
| |
| |
|
