Abnormal Return Definition
An abnormal return, in finance, refers to the excess or deficit in an investment or portfolio’s actual return as compared to the expected return. The expected return on an asset is usually calculated based on the asset’s beta (systematic risk), the market return, and the risk-free rate.
Calculation of Abnormal Return
The abnormal return of a security, such as a stock, is calculated using a specific mathematical formula. The formula can be written as:
Abnormal Return = Actual Return - Expected Return
Actual Return
The 'Actual Return' part of the formula is the real return achieved by the stock, or in other words, the profit (or loss) made by an investor from the stock during the period under consideration. It takes into account both capital appreciation as well as income generated in the form of dividends.
For instance, if an investor buys a stock for $100 and sells it later for $120, and also receives a dividend of $5, then the actual return on the stock is 25% (($120 + $5 – $100)/$100).
Expected Return
'Expected Return', on the other hand, is the return that the stock is expected to generate based on a specific model, like the Capital Asset Pricing Model (CAPM). Basically, it's the return that takes into account the risk-free rate, the systematic risk, and the expected market return.
Here's an adaptation of the CAPM, used to calculate expected return:
Expected Return = Risk-free rate + Beta * (Market Return - Risk-free rate)
Where,
- The risk-free rate is the theoretical rate of return of an investment with no risk of financial loss.
- Beta represents the stock's sensitivity to systematic risk or market risk.
- The market return is the average return of the entire market.
The Error Term
The difference between the actual return and the expected return is the 'error term'. If the actual return is greater than the expected return, the error term is positive, indicating an abnormal gain. Conversely, if the actual return is less than the expected return, the error term is negative, indicating an abnormal loss.
In essence, 'Abnormal Return' measures the performance of a stock vis-à-vis the performance predicted by an equilibrium model like CAPM, thereby serving as an indicator of the 'extra' value generated by the stock.
Factors Affecting Abnormal Returns
Several factors can play a major role in affecting the abnormal return of a financial asset. These could be anticipated or unanticipated influences based on various elements such as macroeconomic factors, company related information, and market unpredictability.
Macroeconomic Factors
Economic elements on a wider national or global scale, also termed as macroeconomic elements, can deeply impact the abnormal returns of a financial asset. These might include inflation rates, interest rates, national income, gross domestic product (GDP), or unemployment rates. For instance, an unexpected rise in the interest rates by a central bank can negatively impact stock prices, leading to a negative abnormal return.
Company Related Information
Detailed information related to a particular company can also significantly influence the abnormal return. These can include elements like the company's earnings reports, changes in upper management, introduction of a new product or service, acquisitions and mergers, or legal investigations. The announcement of unexpectedly high quarterly earnings, for example, can lead to positive abnormal returns as investors may feel more encouraged to invest in the company's stock.
Market Unpredictability
The unpredictability or volatility of the financial market is another factor affecting abnormal returns. During periods of high market uncertainty or instability, the possibility of large abnormal returns (either positive or negative) increases. These unpredictable fluctuations could be caused by various events or incidents such as political unrest, natural disasters, or a global pandemic.
Overall, it's crucial to understand that these factors capable of generating abnormal returns are largely unpredictable and go beyond just understanding the basic concepts and strategies of investment. Intelligence and foresight about these factors, combined with smart strategies, can assist investors in achieving abnormal returns.
Abnormal Return and Risk Assessment
In the finance sector, abnormal return is often utilized as a tool for risk assessment. It offers valuable insights into investment performance, particularly when gauged against anticipated returns on investments. Any deviation from expected return, deemed as the 'norm', signifies a risk. Therefore, the discrepancy between actual and predicted returns, i.e., the abnormal return, is essentially a measure of risk borne by investors.
Utilization in Systemic and Unsystemic Risk
The designation of risk in the financial realm is broken down into two categories: systemic and unsystemic risk.
Systemic Risk
Systemic risk relates to the potential for collapse that can cascade throughout the entire financial system or a market. Remarkably, abnormal returns can be indicative of systemic risk.
For instance, during a financial crisis, investments across the board could generate negative abnormal returns. This suggests that there is an issue not just with individual investments, but a broader, more systemic problem. The presence of abnormal returns on numerous investments, specifically negative returns, could warn of lurking systemic risk.
Unsystemic Risk
On the flip side, abnormal return can also gauge unsystemic risk, those unique or specific to a particular industry, company or region. These risks can arise from internal factors such as company management or production issues, or external conditions like a change in regulation affecting a specific sector.
If an individual investment yields an abnormal return whilst others remain close to their expected return, this may signal an unsystemic risk. For example, if shares in a particular company return much higher profits than expected, this could indicate that the company is outperforming the market. Alternatively, it might suggest the investment is more risky than anticipated, as high returns usually come hand-in-hand with high risk.
Investors rely on this information to decide on whether they should adjust their portfolio, in order to manage both systemic and unsystemic risks. This utilization of abnormal return in risk assessment helps investors to make more informed financial decisions, yielding a better investment strategy with knowledge of potential risks and restitutions.
Importance of Abnormal Returns
Let's delve into the importance of calculating abnormal returns.
Role of Abnormal Returns in Investment Analysis and Decision-Making
When assessing investment opportunities, abnormal returns act as a crucial gauge in the decision-making process. Calculating abnormal returns can help investors determine if a security or portfolio is outperforming or underperforming relative to its expected return based on its risk profile and market conditions.
For example, if a specific stock consistently generates positive abnormal returns, it may indicate that the company is performing better than expected under current market conditions. This information can be instrumental in making decisions such as buying, selling, or holding the security. On the other hand, a negative abnormal return can alert investors to potential problems that might warrant further investigation.
Abnormal Returns in Financial Modeling
Within the realm of financial modeling, abnormal returns are often incorporated to assess the effectiveness of a model. They can help in estimating future returns of an asset in various scenarios.
Often, abnormal returns are used to "stress-test" financial models, by revealing how the asset or portfolio would perform given unexpected or extreme market conditions. Moreover, positive or negative abnormal returns, when evaluated over larger periods, can offer insights that potentially suggest adjustments or refinements in the financial model.
Evaluation of Portfolio Performance
In the realm of portfolio management, abnormal returns play a pivotal role in assessing the performance of a portfolio against a benchmark like a market index, or a comparable set of investments. An investor or portfolio manager strives to achieve positive abnormal returns, as it signifies that the portfolio is yielding higher returns than what would be predicted based on its risk level and the current state of the market.
The ability to consistently achieve positive abnormal returns suggests that a manager or investor is skillful, and their strategy is effective. Conversely, consistent negative abnormal returns might prompt a review and possible adjustment of investment strategy.
In essence, the analysis of abnormal returns is not just a measure of past success or failure but, more crucially, it's an essential tool for informed decision-making, refining strategies and mitigating future risks.
Abnormal Returns in Asset Pricing Models
In many asset pricing models, abnormal returns play a significant role in determining the price of a financial security. Let's explore how this works in two common models: The Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT).
Capital Asset Pricing Model (CAPM)
CAPM uses abnormal returns to gauge the expected performance of an investment, considering systematic risk. The model proposes that the expected return depends on the risk-free rate, beta (the sensitivity of a security's returns to market returns), and the expected market return. Hence, an abnormal return in the context of CAPM would be when the actual return deviates from this expected return.
For instance, consider a situation where the CAPM predicts a return of 7% but the actual return is 9%. This extra gain is an abnormal return. These abnormal returns, whether positive or negative, could be a result of various factors; company news, earnings reports or market sentiment are all potential influencers.
Arbitrage Pricing Theory (APT)
APT, on the other hand, accounts for multiple systematic risk factors, unlike CAPM. In a simplified sense, it's an extension of the CAPM that introduces more variables into the equation. Such factors may include changes in inflation, changes in the levels of industrial production, shifts in market return and others.
In the APT context, abnormal returns are interpreted slightly differently than in the CAPM model. An abnormal return occurs when the actual rate of return deviates from the rate predicted by the multiple-factor formula. These differences may highlight inefficiencies in the pricing of a security, providing an opportunity for arbitrage.
Again, like with CAPM, these abnormal returns could be a result of several factors. But in APT's case, it also could indicate a deviation from the model's risk factors.
From these two models, we can see that abnormal returns provide crucial insight into the performance of a security above the expected return, suggesting either higher risk-taking or inefficiencies in the market.
Efficient Market Hypothesis and Abnormal Returns
To understand how the Efficient Market Hypothesis (EMH) relates to abnormal returns, we first need to remember what EMH is. According to the EMH, a theory widely accepted by many financial experts and academics, all relevant information about an asset (e.g., a stock or a bond) is fully and immediately reflected in its price.
EMH and the Possibility of Abnormal Returns
In the context of the EMH, abnormal returns should theoretically not exist. If markets are perfectly efficient and instantaneously reflect all relevant information, then no investor, regardless of their skills or the amount of effort they put into analysis, should be able to consistently achieve returns above the average market return on a risk-adjusted basis.
Let's take a simplified example. If a stock is currently priced at $10 and the correct value based on all available public information is also $10, then as an investor, you would gain no advantage by having this public information. You can't buy the stock at a discount or sell it at a premium because the market has already incorporated all known information into the stock’s price.
Implications of EMH
The implication of the EMH is that consistently generating abnormal returns, either positive or negative, isn't possible because no investor has a persistent informational advantage over others. The only potential source of higher return – given the risk profile – is luck or randomness, not superior skill or information.
This doesn't mean that abnormal returns are not seen in reality. They do occur, but EMH proponents would argue that such occurrences are chance events – simply outliers in an otherwise efficient market – rather than the result of skill or specific knowledge.
Further, it's important to note that the EMH doesn't claim that markets are always correctly priced. Instead, it insists that errors in pricing are random and not predictable, making it unlikely for an investor to systematically profit from them.
This outlook casts a pessimistic view for those aiming to ‘beat the market’. The implications of EMH often form the basis for passive investing or the argument for preferring index funds over actively managed funds. Quite simply, if markets are efficient and all information is already incorporated into prices, the time and effort spent trying to find undervalued or overvalued securities may be better spent elsewhere.
Negative Abnormal Returns
Negative abnormal returns are the negative deviations from the expected or normal return of an investment. These can happen due to various reasons, including poor company performance, unexpected news about the market or the company, or changing market trends.
Causes of Negative Abnormal Returns
Market Efficiency Hypothesis (MEH) suggests that the current prices of securities fully reflect all available and relevant information. However, if the actual returns are less than the expected returns, the situation can lead to negative abnormal returns. Sometimes fluctuations in the market can also be a primary cause of these returns.
Poor Company Performance
Poor company performance is a common cause of negative abnormal returns. An unexpected decline in sales or an increase in expenses can lead to a fall in the share prices which in turn causes negative abnormal returns.
Unforeseen Market News
When unexpected news or information about a company hits the market, it may result in a share price drop. For example, the sudden announcement of a CEO resignation or the filing of bankruptcy can dramatically bring down the company’s share price and cause negative abnormal returns.
Changing Market Trends
Market trends are a significant factor that influences the returns on investments. Any changes in these trends can affect the share prices and result in negative abnormal returns.
Implications of Negative Abnormal Returns on Investors’ Decisions and Portfolio Management
Negative abnormal returns can greatly influence investors' decisions and the way they manage their portfolios. Investors often see negative abnormal returns as loss signals and may look to sell off their stocks. This could create a selling domino effect in the market, leading to more share price falls and more losses for investors.
Influencing Investment Decisions
Negative abnormal returns can often prompt investors to reconsider their current investments and make changes in their investment strategy. For instance, they might want to move their investments to safer or better-performing assets.
Impacting Portfolio Management
Similarly, portfolio managers may have to adjust their strategies in the face of negative abnormal returns. They might need to rebalance their portfolios, perhaps by selling off the underperforming assets and investing more in assets that are expected to yield higher returns.
In conclusion, negative abnormal returns have significant implications for investors and portfolio managers alike. Understanding these implications can help them make better-informed investment decisions.
Abnormal Returns and Corporate Social Responsibility
In understanding the role of Corporate Social Responsibility (CSR) in influencing abnormal returns, it is key to look at the dovetail of both. The economic theory of CSR posits that companies undertaking socially responsible activities might experience abnormal returns due to investors' changed perceptions of the company's future prospects.
CSR and Stakeholders' Perception
CSR activities often result in a more positive perception of a company by its stakeholders. As a result, such activities might steer a company's stock price away from its anticipated trajectory. For example, they may cause a price increase if stakeholders perceive the CSR activities as indicative of good management practices. This price deviation may be seen as an abnormal return driven by the CSR activities.
Empirical Evidence
Findings from studies mirror these theoretical predictions. For instance, a 2015 research piece by Deng, Kang, and Low offers that companies involved in CSR, earn statistically significant positive abnormal returns. This study indicates that investors view firms engaged in CSR positively, rewarding them in the form of higher stock prices.
Similarly, another research published in the Journal of Business Ethics found a positive relationship between CSR and abnormal return. This study was carried out across four Asian economies involving firms with high and low CSR scores. It revealed that firms with higher CSR scores consistently demonstrated positive abnormal returns.
The provision of positive abnormal returns, thus, may be the result of CSR activities that usher confidence in the investors. This reveals that a company not only cherishes its profits but also values social causes. It sends out a message that the company is willing to go the extra mile to ensure that it has a sustained positive impact on society.
These findings underscore how CSR practices can be a powerful tool not only for community enriching contributions but also as a means to add value to an investment portfolio. As more investors become socially aware, the correlation between CSR efforts and abnormal return will likely increase in importance.
In conclusion, it is evident that the impact of CSR activities on abnormal returns has a substantial backing. Corporate managers might find it beneficial to incorporate CSR undertakings into their overall business strategy. Investors, in turn, may want to pay more attention to companies with extensive CSR activities, given their potential link with positive abnormal returns.
