Abnormal return definition
The unexpected profit earned from securities or a portfolio for a specific period
What is abnormal return?
Every investor is anticipating a certain level of profit to be generated by their investments. The expected profit can be predicted by the Capital Asset Pricing Model (CAPM). This model is used to calculate expected return, taking into account the risk-free rate of return, expected market return, and beta. Profit levels, which are above or below the anticipated return, could be classified as abnormal profits, i.e. abnormal return.
This represents the difference between the actual profit and the expected profit. The abnormal return is also called ‘alpha’ or ‘excess return’. There could be a positive or negative abnormal return.
Positive abnormal return: If the actual return is 10% and the expected return is 7%, then it could be said that there is a positive excess return of 3%.
Negative abnormal return: If the actual return is 4%, while the anticipated return is 7%, then there is a negative abnormal return of 3%. It should be stated that the investor is still making a positive return of 4%, but the abnormal return is negative since it is lower than the expected return.
Abnormal returns are used for evaluating a stock’s performance against the market performance. It can also help to identify the effects of different factors on stock prices and portfolio value.
Cumulative abnormal return (CAR) is used when investors want to analyse the effects of announcements and news on stock prices. It is calculated as the sum of abnormal returns during previous periods for a given stock or portfolio.
CAR can be used for the evaluation of the effectiveness of the CAPM model to forecast expected returns successfully.
Determinants of abnormal return
Abnormal returns can happen due to different company-related announcements. The occurrence of a positive or negative abnormal return depends on the types of news and investors’ perception about the effects. A stock split, merger and acquisition, earnings announcement or dividend announcement could impact stock prices.
Dividend yields can lead to abnormal returns when the news about paying higher than expected dividends is announced. Higher dividends would produce higher dividend yields, which could give the perception that the company is doing well. It will also attract investors who will want to gain access to higher dividends by purchasing stocks.
Abnormal return can be incorporated into an investing strategy, because it can show the reaction of the market and investors to different announcements.
