Sales & Trading Interview Practice Test

Alpha is the portion of a portfolio’s return that comes from the manager’s skill, after you account for the risk you took from market movements. In practice you look at how much return the portfolio produced beyond what its exposure to the market would predict. That predictive part comes from beta and the market's overall move, usually via a CAPM framework or a regression of portfolio excess returns on market excess returns. If the actual return is higher than the return expected from that exposure, the difference is alpha. For example, suppose the market earns 8% and the risk-free rate is 2%. If a portfolio has a beta of 1, its expected return under CAPM is 2% + 1*(8%-2%) = 8%. If the portfolio actually returns 12%, the alpha is 4 percentage points. That extra 4% is attributed to the manager’s ability to add value beyond simply riding the market. This concept is distinct from beta, which measures how sensitive a portfolio is to market moves (its market risk), and from duration, which relates to how a bond’s price moves with interest rates. Positive alpha suggests outperformance after adjusting for risk, while negative alpha suggests underperformance after such adjustment. However, alpha isn’t a guarantee—it can reflect luck or other factors not captured in the model.