What is Abnormal Return?

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Abnormal Return refers to the portion of an investment portfolio or individual stock's actual return that exceeds or falls short of the expected return, typically used to assess investment performance or market reaction.

Definition

Abnormal returns refer to the portion of actual returns from a portfolio or individual stock that exceeds or falls short of expected returns, often used to assess investment performance or market reactions.

Origin

The concept of abnormal returns originated in financial market analysis, particularly in event studies, to measure the impact of specific events on stock prices. In the 1960s, with the development of capital market theory, abnormal returns became an important tool for evaluating market efficiency.

Categories and Features

Abnormal returns can be categorized into positive abnormal returns and negative abnormal returns. Positive abnormal returns indicate that actual returns exceed expected returns, often seen as a sign of successful investment. Negative abnormal returns indicate that actual returns are below expected returns, possibly reflecting a negative market reaction to certain information. The calculation of abnormal returns is typically based on market models or event study methods, helping investors identify unusual market reactions.

Case Studies

A typical case is Apple's stock performance after a new product launch. Suppose the market expects Apple's stock to rise by 5% after the launch, but it actually rises by 8%; the 3% difference is a positive abnormal return. Another example is Tesla's stock performance after announcing quarterly earnings. If the market expects a 2% drop, but the stock actually falls by 5%, the 3% difference is a negative abnormal return.

Common Issues

Common issues investors face when applying the concept of abnormal returns include accurately predicting expected returns and interpreting the sources of abnormal returns. Misunderstandings may arise from mistaking short-term market fluctuations for abnormal returns, while overlooking the importance of long-term trends and fundamental analysis.

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Pooled Funds

Pooled funds are funds in a portfolio from many individual investors that are aggregated for the purposes of investment. Mutual funds, hedge funds, exchange traded funds, pension funds, and unit investment trusts are all examples of professionally managed pooled funds. Investors in pooled funds benefit from economies of scale, which allow for lower trading costs per dollar of investment, and diversification.

Giffen Good

A Giffen good is a low income, non-luxury product that defies standard economic and consumer demand theory. Demand for Giffen goods rises when the price rises and falls when the price falls. In econometrics, this results in an upward-sloping demand curve, contrary to the fundamental laws of demand which create a downward sloping demand curve. The term "Giffen goods" was coined in the late 1800s, named after noted Scottish economist, statistician, and journalist Sir Robert Giffen. The concept of Giffen goods focuses on a low income, non-luxury products that have very few close substitutes. Giffen goods can be compared to Veblen goods which similarly defy standard economic and consumer demand theory but focus on luxury goods.Examples of Giffen goods can include bread, rice, and wheat. These goods are commonly essentials with few near-dimensional substitutes at the same price levels.

Base Effect

The Base Effect refers to the significant impact on year-over-year data comparisons due to changes in the base period's value. This effect is common in economic data analysis, especially in indicators like inflation rates and GDP growth rates. When the base period value is high, even a substantial increase in the current period's value may result in a seemingly small year-over-year growth rate; conversely, when the base period value is low, even a modest increase in the current period's value may appear as a large year-over-year growth rate. For instance, if the inflation rate was unusually low in a particular month last year, this year's inflation rate for the same month might show a high year-over-year increase even with a slight rise. This phenomenon must be considered when analyzing economic data to avoid misleading conclusions.

Gini Index

The Gini index, or Gini co-efficient, measures income distribution across a population. Developed by Italian statistician Corrado Gini in 1912, it often serves as a gauge of economic inequality, measuring income distribution or, less commonly, wealth distribution among a population.The co-efficient ranges from 0 (or 0%) to 1 (or 100%), with 0 representing perfect equality and 1 representing perfect inequality. Values greater than 1 are theoretically possible due to negative income or wealth.

Fund Flow

Fund Flow refers to the movement of money into and out of financial instruments, asset classes, or markets over a specific period. It reflects investor behavior and market trends. Fund flow can be divided into fund inflow and fund outflow: fund inflow indicates that investors are putting money into a particular asset or market, while fund outflow indicates that investors are withdrawing money from it. By analyzing fund flows, investors can understand the direction of money, gauge market sentiment, and make informed investment decisions. For example, significant fund inflows into a market or asset class may indicate investor optimism, while outflows may suggest pessimism. Analyzing fund flows is crucial for studying and forecasting financial markets.

Underlying Security

An Underlying Security refers to the asset or security on which a financial derivative (such as options, futures, swaps, etc.) is based. It forms the foundation of the derivative's value. For example, the underlying security of a stock option is a specific stock, and the underlying security of an index future is a specific stock index. Underlying securities can include various asset types, such as stocks, bonds, commodities, currencies, interest rates, and market indices. Investors trade derivatives based on the underlying securities to achieve purposes like hedging, speculation, or arbitrage. Understanding the characteristics and market performance of the underlying security is crucial for the effective use of derivatives.