Question

Discuss why rational investors may not have arbitrage when abnormal return (actual return-expected return obtained from CAPM) is positive

Answer 1

Abnormal returns are important in determining a security's or portfolio's risk-adjusted output when compared to the overall index. Abnormal returns helps in identify a manager's skill on a risk-adjusted basis. It will also illustrate whether investors received sufficient compensation for the amount of investment risk assumed.

The systematic risk of an investment is measured by the covariance of an investment's return with the returns of the market.The typical risk-averse investor seeks high returns and low risks.

In given case, if CAPM is positive, it is difficult for rational investors to arbitrage as there is a linear relationship between risk and return i.e. high risk associated with the high return and low risk with the low return.

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%.