Alternative Investments: CAIA Level I, 3rd Edition

CHAPTER 8 Alpha, Beta, and Hypothesis Testing

Chapter 6 discussed a number of measures of the price risk of options using Greek letters, such as delta, theta, and gamma. Greek letters and other similar-sounding words, such as vega, are not limited to option analysis. This chapter begins with a detailed discussion of alpha and beta. Alpha and beta are central concepts within alternative investment analysis. Consider the following hypothetical example of a discussion of investment performance:

During an investment committee meeting, the chief investment officer (CIO) comments on the performance of a convertible arbitrage fund named MAK Fund: “MAK generated an alpha of 8% last year and 10% two years ago. I think we can expect an alpha of 4% next year.” A portfolio manager debates the point: “MAK Fund takes positions in convertible bonds with high credit risk. I think that MAK's alpha during the last two years was really beta.” The CIO replies: “But MAK is delta hedged. And even though the fund is long gamma, is there really any beta in being long gamma?”

8.1 Overview of Beta and Alpha

The preceding example illustrates how Greek letters are often used in investments to represent key concepts. This chapter focuses on alpha and beta, two critical concepts in the area of alternative investments. In a nutshell, alpha represents, or measures, superior return performance; and beta represents, or measures, systematic risk. A primary purpose of this chapter is to explore their meanings ...