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An abnormal return refers to the generation of unusual profits over a specified period of time, by the given portfolios or securities. The performance differs from the anticipated RoR (rate of return). The anticipated RoR is the expected return. The same is calculated as per the asset pricing model using multiple valuations and historical average.
These abnormal returns are also termed as the excess returns or the alpha returns.
Why are the abnormal returns important?
While comparing to a benchmark index or the overall market, the abnormal return essentially help in determining the adjusted performance of a portfolio’s risk. Abnormal returns help identify the skills of a portfolio manager on the basis of risk adjustment.
The abnormal return can assume both negative and positive turns. The figure is a summary of the difference between the predicted and the actual returns. For instance, if a mutual fund earns 30% while the expected is 10% average per annum, the positive abnormal yield is 20%. Alternatively, if the actual return comes out to be 5%, the negative abnormal yield is 5%.
Cumulative Abnormal Return
CAR is the sum of all abnormal returns. Usually, it is calculated over a short time window. This generally extends to a few days. Daily compounding of abnormal returns creates a return bias and hence, the duration is kept short. It is beneficial for measuring effects of different events on the stock prices, buyouts and lawsuits. It also helps determine the asset pricing model’s accuracy for predicted the performance.
CAPM or the capital asset pricing model is a framework for calculating the expected return of a portfolio or security. It is based on the expected return from the market; the beta and risk free RoR. After calculating the expected return, the abnormal return is estimated by subtraction of expected from the realized return.
Key Takeaways
- An abnormal return gives the description of unusual profits that a specific portfolio or security generates over a time period.
- Abnormal returns help in determining the risk adjusted performance. Based on the portfolio or security and its performance, they can either be positive or negative.
- The total of all abnormal returns gives the cumulative abnormal return.
- CAR is beneficial for measuring effects of different events on the stock prices, buyouts and lawsuits.
An Example from the Real World
Assuming a 2% risk free RoR and the benchmark index to have a return expected as 15%. If you hold a portfolio of securities and wish to calculate the abnormal return from it during last year, here’s how to do it.
The return from the portfolio is 25% and the beta is 1.25 against the benchmark index. Therefore, with the risk involved, the return should have been 18.25% = 2%+1.25(15%-2%)
Consequently, the abnormal return is 25 to 18.25% or 6.75%.
