What is abnormal return and how is it calculated?

FinanceBanking & FinanceTrading

Abnormal return refers to abnormally high or low returns of investment. In the case of an abnormal return, the performance of the investment or funds diverges from the anticipated and usual rate of return. The effects of abnormal return are short-term and they may be due to abnormal fundamentals or fraudulent behavior of the firm holding the funds. The estimated Rate of Return (RoR) which is risk-adjusted remains completely missing in case of abnormal returns.

Abnormal return is different from Alpha and excessive returns which are due to the good performance of the investments managers. Cumulative Abnormal Returns (CAR) are a collective amount of all the returns that affect the stock prices through its behavior of lawsuits, buyouts, etc.

How to Calculate Abnormal Returns?

Abnormal return is used to calculate the performance of a given fund against the market conditions and returns of other funds. It can also show the performance of the fund manager in a given portfolio that inflates or deflates abnormally during a specified period.

Abnormal returns can be either positive or negative. For example, for security that offers a 40% return where the expected return is 15%, the positive rate of positive abnormal return is 25%. If the actual return is 5%, the negative abnormal return is 20%.

Capital Asset Pricing Model (CAPM) is used to calculate the abnormal return using a risk- free rate of return, anticipated market return, and beta. The value of the abnormal return is obtained by subtracting the normal return from the expected market return.

Example

If a security’s risk-free rate of return is 3% and the benchmark index shows a return of 20%. The portfolio returned 35% and a beta of 2 against the benchmark index.

Therefore, the given return of the security is {3% + 2 x (20-3)} =37%. Consequently, the abnormal rate of return is 37 – 20 = 17%.

Points to Note

  • The abnormal return graph diverges away from the expected return graph in general.

  • Capital Asset Pricing Model is used to calculate abnormal returns.

raja
Published on 27-Jul-2021 10:34:07
Advertisements