ABNORMAL RATE OF RETURN

Definition: Abnormal rate of return or ‘alpha’ is the return generated by a given stock or portfolio over a period of time which is higher than the return generated by its benchmark or the expected rate of return. It is a measure of performance on a risk-adjusted basis.

Description: The abnormal rate of return on a security or a portfolio is different from the expected rate of return. It is the return generated by a security or a portfolio which is in excess of its benchmark or the return predicted by an equilibrium model such as capital asset pricing model (CAPM). Abnormal rate of return can either be positive or negative depending on how the security or a fund has performed in comparison to its benchmark. The normal rate of return can be a forecasted return based on model or it can be the return on an index, such as S&P BSE Sensex or 50-share Nifty index.

The abnormal return on an investment is calculated as follows (1): RAbnormal = RActual – RNormal An investment’s abnormal return could be positive or negative. It essentially measures how the stock or a fund has performed over a given period of time. Abnormal rate of return as a measure of performance is useful to investors as a valuation tool and for comparing returns to market performance (2).

Example:

Suppose a stock ABCD experiences a 30% return in a given year. Analysts expected ABCD to experience a return of 20% for that year. The (positive) abnormal rate of return ABCD is:

30% actual return – 30% projected return = 10% positive abnormal return

ABCD experience a positive abnormal return of 10% during that year.


Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s