Abnormal returns refer to the difference between the actual return on an investment and the expected return based on its risk profile or a relevant benchmark. Calculated as the actual return minus the expected return, abnormal returns indicate whether an investment has outperformed or underperformed relative to expectations.
A positive abnormal return signifies superior performance, while a negative one indicates underperformance. Investors and analysts use abnormal returns to evaluate investment strategies, assess portfolio performance, and analyze the effects of specific events on asset prices. Understanding abnormal returns is essential for identifying opportunities and measuring the effectiveness of investment decisions.
Key Features of Abnormal Return
Calculation: The formula to calculate abnormal return is:
Abnormal Return=Actual Return−Expected Return
- Actual Return: The return that an investment actually generates over a specific period.
- Expected Return: The return anticipated based on a model (like the Capital Asset Pricing Model (CAPM)), which considers the risk-free rate and the investment’s systematic risk (beta).
Types of Returns:
- Positive Abnormal Return: Occurs when the actual return exceeds the expected return. This indicates that the investment has performed better than anticipated.
- Negative Abnormal Return: Occurs when the actual return falls below the expected return, indicating underperformance.
Expected Return Models: To calculate the expected return, several models can be used, including:
- Capital Asset Pricing Model (CAPM): Estimates expected return based on the risk-free rate, the investment’s beta, and the expected market return.
- Fama-French Three-Factor Model: Expands on CAPM by including size and value factors along with market risk.
- Historical Averages: Using historical performance data to estimate future expected returns.
Applications:
- Performance Evaluation: Abnormal returns are commonly used by investors and portfolio managers to evaluate the effectiveness of their investment strategies or fund performance.
- Event Studies: In finance, abnormal returns are used to analyze the impact of specific events (e.g., earnings announcements, mergers) on stock prices.
- Risk Assessment: Helps investors understand whether the risk taken in a particular investment is yielding satisfactory returns.
Significance:
- Abnormal returns provide valuable insights into market efficiency and investor behavior. A consistently positive abnormal return may indicate mispricing in the market or an investor’s ability to generate alpha, which represents excess returns earned above a benchmark.
Market Efficiency:
- In an efficient market, all available information is reflected in asset prices, making it difficult to achieve abnormal returns consistently. However, anomalies and opportunities for abnormal returns may arise due to market inefficiencies, behavioral biases, or asymmetrical information.
Example of Abnormal Return
Suppose an investor purchases shares of Company A, and over one year, the following returns are observed:
- Actual Return: 15%
- Expected Return (based on CAPM): 10%
The abnormal return can be calculated as follows:
Abnormal Return=15%−10%=5%
In this case, Company A has generated a positive abnormal return of 5%, indicating it performed better than expected.
Conclusion
Abnormal return is a vital concept in finance that helps investors assess the performance of investments relative to expectations based on risk. By calculating abnormal returns, investors can evaluate the effectiveness of their strategies, analyze the impact of specific events, and gain insights into market efficiency. Understanding abnormal returns is crucial for making informed investment decisions and identifying potential opportunities for superior performance.
