Abnormal return is the difference between an asset’s actual and expected returns based on a benchmark or model. It measures how much better or worse the asset performed than expected and is frequently used to assess the impact of specific events.
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What is Abnormal Return?
An abnormal return is one that differs from an investment’s expected return based on a benchmark or model, such as the Capital Asset Pricing Model (CAPM). It measures how much better or worse the asset performed compared to what was anticipated under normal market conditions.
The presence of abnormal returns, which can be positive or negative in nature, supports investors to calculate risk-adjusted performance.
Abnormal returns occur when an asset’s performance deviates from expectations due to factors like earnings surprises, market events, investor sentiment, or company-specific news.
Interpretation of Abnromal Return
Abnormal returns are frequently used to assess how specific events, such as earnings releases, mergers, or regulatory changes, affect an asset’s performance.
Abnormal return can be either positive or negative.
- Positive Abnormal Return: This indicates that the asset outperformed expectations, possibly due to unusual factors such as favorable news, earnings surprises, or strong management actions.
- Negative Abnormal Return: Indicates that the asset underperformed expectations, possibly due to adverse events, poor management decisions, or low market sentiment.
Formula
where:
- : Risk-free rate
- : Market return
- : Sensitivity of the asset to the market
Example
Suppose an investor holds a portfolio of securities and is expecting to generate an abnormal return. Let’s assume a risk-free rate of 4.5%, and the benchmark index has an expected return of 13.5%.
This year the investor has generated a return of 22.8% and had a beta of 1.2 measured against the benchmark index.
Hence, according to CAPM, his expected return should be
(4.2% + 1.2*(13.5-4.5)) = 15%
Consequently, the abnormal return during the previous year was 7.8% or 22.8% – 15%.
The same calculations can be useful for stock investments. For example, stock XYZ returned 8% and had a beta of 2 when compared to its benchmark index. Consider that the risk-free rate of return is 5%, while the benchmark index has an expected return of 12%. According to the CAPM, stock XYZ is expected to return 19%. As a result, stock ABC experienced an abnormal return of -11% and underperformed the market during this period.
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