Abnormal Return - Explained
What is an Abnormal Financial Return?
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Table of ContentsWhat is an Abnormal Return?How do Abnormal Returns Happen? Academic Research for Abnormal Return
What is an Abnormal Return?
The benefits expected from a specific portfolio or security beyond its expected return over a certain period of time are termed as abnormal returns. The abnormal return is not the expected return since it exceeds of what was expected.
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How do Abnormal Returns Happen?
With abnormal returns, you can find the risk-adjusted performance of a portfolio in relation to usual market standards and benchmark indexes. Hence, you can know whether your investments are sufficiently compensated for the risk you are assuming. An abnormal return is obtained by subtracting actual returns from the forecasted ones, and thus, can be positive or negative. A mutual fund with 12% average return expected a year, if delivers 26% return, it implies 14% abnormal return. On the contrary, if it actually gave 3% return, you will get negative 9% anomaly return. The Capital Asset Pricing Model (CAPM) determines the expected return rate for a specific portfolio or security, considering risk-free returns, expected market returns and beta. Once you determine expected income, you can determine abnormal income by subtracting expected yield from realized return rate. Abnormal returns are dependent on the securitys or portfolios performance. For instance, consider a risk-free return 2% and benchmark return as 15%. Now if you want to know the abnormal income of your portfolio for the last year, then relative to the benchmark index, your portfolio is carrying 1.25 beta and 25% return. Hence, taking into an account the risk, your portfolio must give 18.25% return , implying your abnormal return rate of last year as 6.75%. The same procedure is applied for the stocks.