FRM Part II · FRM Exam Part II · Portfolio Construction
A manager's portfolio has a beta of 1.2 against the market. Over the year the portfolio returned 14%, the risk-free rate was 3%, and the market returned 10%. Using CAPM, what is the portfolio's alpha?
Alpha is 2.6%. The CAPM required return is 3% plus beta 1.2 times the 7% market premium, which equals 11.4%. Subtracting this from the realized 14% leaves 2.6%. Comparing with the market return alone would ignore the portfolio's higher systematic risk.
- A2.6%Correct
- B3.0%
- C4.0%
- D11.0%
Explanation
CAPM expected return = 3% + 1.2 x (10% - 3%) = 3% + 8.4% = 11.4%. Alpha = 14% - 11.4% = 2.6%. Option 4.0% compares with the market return only (14 - 10), ignoring beta. Option 3.0% subtracts the risk-free rate in the wrong place; 11.0% is not alpha but excess return over the risk-free rate.
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