Alpha, Beta, and Hypothesis Testing

Question 1

Provide 2 common interpretation of the term alpha

Answer 1

• Any excess or deficient return after the return has been adjusted for the time value of money (the risk free rate) and for the effects of beta.
• Can also refer to the extent to which the skill, information, and knowledge of an investment manager generates superior risk-adjusted returns.

Question 2

Provide 2 common interpretations of the term beta

Answer 2

• The proportion by which an asset’s excess return moves in response to the market portfolio’s excess return (the return of the asset minus the return of the riskless asset).
• Beta refers to any of a number of measures or the bearing of risk, wherein the underlying risk is systematic (shared by at least some other investments and usually unable to be diversified or fully hedged out without costs) and is potentially rewarded with expected return without necessarily specifying that the systematic risk is the risk of the market portfolio.

Question 3

Does ex ante lead to ex post alpha?

Answer 3

Not necessarily.

Question 4

What are the two steps to an analysis of ex ante alpha using historical data?

Answer 4

Use an asset pricing model or benchmark to divide the historical returns into the portions attributable to systematic risks and those attributable to idiosyncratic effects.

The remaining returns, meaning the idiosyncratic returns, should be statistically analysed to estimate the extent, if any, to which the superior returns may be attributable to skill rather than luck.

Question 5

List the 3 major types of model misspecification in the context of estimating systematic risk.

Answer 5

• Omitted
• Misestimated betas
• Nonlinear risk-return relationships

Question 6

What is the goal of an empirical investigation of abnormal return persistance?

Answer 6

to identify ex ante alpha

Question 7

What is the term for investment products trying to deliver systematic risk exposure with an emphasis on doing so in a highly cost effective manner

Answer 7

beta drivers

Question 8

Does an analyst select a p-value or a significance level in preparation for a test

Answer 8

Significance level.

P value is the output of the statistical computations.

Question 9

What is the relationship between selection bias and self-selection bias in hedge fund datasets.

Answer 9

Selection bias is a distortion in relevant sample characteristics from the characteristics of the population.

If the selection bias originates from the decision of fund managers to report or not to report their returns, then the bias is referred to as a self-selection bias.

Question 10

What are two methods of detecting outliers in statistical analysis.

Answer 10

• Visual detection

- Ordered listings of the variables and regression residuals.