Question

The abnormal return of a security derived from CAPM is positive(expected return get from CAPM -actual return which is given).

a. What rational explanation could exist for the abnormal returns？

b. Discuss one behavioural bias that could explain the positive abnormal return?

c. Discuss why rational investors may not have arbitraged this apparent profit opportunity?

Answer 1

A.What rational explanation could exist for the abnormal returns？

Answer- An abnormal return describes the unusual profits generated by given securities or portfolios over a specified period. The performance is different from the expected, or anticipated, rate of return (RoR) for the investment. The anticipated rate of return is the estimated return based on an asset pricing model, using a long run historical average or multiple valuations.

Abnormal returns are essential in determining a security's or portfolio's risk-adjusted performance when compared to the overall market or a benchmark index. Abnormal returns could help to identify a portfolio manager's skill on a risk-adjusted basis. It will also illustrate whether investors received adequate compensation for the amount of investment risk assumed.

An abnormal return can be either positive or negative. The figure is merely a summary of how the actual returns differ from the predicted yield. For example, earning 30% in a mutual fund which is expected to average 10% per year would create a positive abnormal return of 20%. If, on the other hand, in this same example, the actual return was 5%, this would generate a negative abnormal return of 5%.

B.Discuss one behavioural bias that could explain the positive abnormal return?

Answer-

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 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 analyze 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 acquisitions, earnings announcements or dividend announcements could impact stock prices. Dividend yields can lead to abnormal returns when the news about paying higher than expected dividends are 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.

C.Discuss why rational investors may not have arbitraged this apparent profit opportunity?

Answer- One of the major factors limiting the ability of rational investors to take advantage of any ‘pricing errors’ that result from the actions of behavioral investors is the fact that a mispricing can get worse over time. An example of this fundamental risk is the apparent ongoing overpricing of the NASDAQ index in the late 1990s. A related factor is the inherent costs and limits related to short selling, which restrict the extent to which arbitrage can force overpriced securities (or indexes) to move towards their fair values. Rational investors must also be aware of the risk that an apparent mispricing is, in fact, a consequence of model risk; that is, the perceived mispricing may not be real because the investor has used a faulty model to value the security.

Even if prices follow a random walk, the existence of irrational investors combined with the limits to arbitrage by arbitrageurs may allow persistent mispricings to be present. This implies that capital will not be allocated efficiently—capital does not immediately flow from relatively unproductive firms to relatively productive firms.

Maclin is evaluating his holding of company stock based on his familiarity with the company rather than on sound investment and portfolio principles. Company employees, because of this familiarity, may have a distorted perception of their own company, assuming a “good company” will also be a good investment. Irrational investors believe an investment in a company with which they are familiar will produce higher returns and have less risk than non-familiar investments.