What Is Abnormal Return?

An in-depth analysis of abnormal returns, exploring the definition, underlying causes, and illustrative examples of this financial concept.

An abnormal return represents the difference between an asset’s actual return and its expected return over a specified period. Calculating an abnormal return is essential for investors and analysts trying to evaluate the effectiveness of a portfolio or the impact of specific events on stock prices.

Causes of Abnormal Returns

Market Efficiency

Abnormal returns can often indicate market inefficiency where the actual price of a security doesn’t reflect all the available information.

Corporate Events

Events such as mergers, acquisitions, earnings announcements, or product launches can cause abnormal returns due to altered perceptions of a company’s future profitability.

Economic Factors

Macro-economic events, including changes in interest rates or significant geopolitical events, can lead to abnormal returns as they influence broad market conditions.

Example of Abnormal Returns

Consider a company’s stock that generally yields a return in line with the broader market, which is projected to return 8% annually. If during a specific year, this stock yields a 15% return due to an unexpected profitable acquisition, the abnormal return would be:

$$ \text{Abnormal Return} = \text{Actual Return} - \text{Expected Return} = 15\% - 8\% = 7\% $$

Calculating Abnormal Returns

Expected Return Models

There are several models to calculate expected returns, such as the Capital Asset Pricing Model (CAPM):

$$ \text{Expected Return (E[R])} = R_f + \beta (R_m - R_f) $$

where \( R_f \) is the risk-free rate, \(\beta\) is the beta of the security, and \( R_m \) is the return of the market.

Statistical Significance

To ensure that abnormal returns are not due to random chance, statistical tests like the t-test can be employed.

Historical Context

Market Anomalies

Historical examples like the tech bubble of the late 1990s, where stocks showed significant deviations from expected returns, help illustrate times when abnormal returns were prevalent.

Famous Case Studies

• Enron Scandal: Enron’s stock went through a period of abnormal returns before its collapse.
• 2008 Financial Crisis: Many stocks exhibited substantial abnormal returns during and after the crisis period.

Applicability of Abnormal Returns

Portfolio Management

Investors use abnormal return analysis to assess the performance of their investment strategies above what could be expected from the overall market or a particular benchmark.

Risk Management

Understanding when abnormal returns occur can help manage and mitigate investment risks through diversification or hedging strategies.

Related Terms

• Alpha: A measure of the active return on an investment compared to a market index.
• Beta: Measures the volatility, or systematic risk, of a security or portfolio in comparison to the market as a whole.

FAQs

What is a normal return?

A normal return is the expected rate of return on an investment, considering the risk and time value of money.

Can an abnormal return be negative?

Yes, an abnormal return can be negative if the actual return is less than the expected return.

Summary

Abnormal returns provide valuable insights for investors and financial analysts by indicating how much of a security’s performance deviates from expected norms due to various internal or external factors. Through careful examination of these deviations, one can assess the impacts of certain events and the efficiency of different market securities. Understanding abnormal returns is crucial for effective portfolio management and investment strategies.

References

1. Sharpe, W. F. (1964). “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”. The Journal of Finance.
2. Fama, E. F. (1970). “Efficient Capital Markets: A Review of Theory and Empirical Work”. The Journal of Finance.
3. Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments. McGraw-Hill Education.