A Risk-adjusted performance measure that represents the average return on a Portfolio over and above that predicted by the CAPM, given the Portfolio's Beta and the average market return. This is the Portfolio's Alpha. In fact, the concept is sometimes referred to as "Jensen's Alpha."
In finance, Jensen's Alpha (or Jensen's Performance Index, ex-post Alpha) is used to determine the excess return of a stock, other Security, or Portfolio over the Security's required rate of return as determined by the Capital Asset Pricing Model. This model is used to adjust for the level of Beta Risk, so that riskier securities are expected to have higher returns. The measure was first used in the evaluation of Mutual Fund managers by Michael Jensen in the 1970's.
To calculate Alpha, the following inputs are needed:
the realized return (on the Portfolio),
the market return,
the Risk-free rate of return, and
the Beta of the Portfolio.
Jensen's Alpha = Portfolio Return - (Risk Free Rate + Portfolio Beta * (Market Return - Risk Free Rate))
Alpha is still widely used to evaluate Mutual Fund and Portfolio manager performance, often in conjunction with the Sharpe Ratio and the Treynor Ratio.