Excess return

Definition

Excess return is the difference between the return of an investment and the return of a benchmark or risk-free rate over a specified period. This concept is crucial as it helps in assessing how well an investment performs relative to a standard, indicating whether the investment has generated a reward for taking on additional risk. In finance, particularly in asset pricing models, excess return serves as a fundamental measure of performance that can guide investors in their decision-making processes.

5 Must Know Facts For Your Next Test

1. Excess return is a key component in the Carhart four-factor model, which assesses performance by including factors such as market risk, size, value, and momentum.
2. A positive excess return indicates that an investment has outperformed its benchmark, while a negative excess return suggests underperformance.
3. In the context of portfolio management, excess returns are essential for evaluating fund managers' performance against relevant benchmarks.
4. The calculation of excess return often requires a suitable benchmark, which can be a market index or the yield on government securities.
5. Excess returns can be annualized to facilitate comparisons across different investments or time periods.

Review Questions

• How does excess return play a role in evaluating the performance of investments within the Carhart four-factor model?
  • In the Carhart four-factor model, excess return is used to evaluate an investment's performance against multiple risk factors including market risk, size, value, and momentum. By measuring excess returns, investors can determine whether a fund manager is generating returns above what would be expected based on these factors. This helps in distinguishing between skill and luck in investment performance.
• Discuss how understanding excess return can influence an investor's decision-making process when selecting investments.
  • Understanding excess return allows investors to compare potential investments against a benchmark or risk-free rate effectively. It highlights whether an investment compensates adequately for the risks taken. Investors can use this information to select investments that align with their risk tolerance and performance expectations, helping them make more informed decisions about where to allocate their capital.
• Evaluate the implications of consistent positive excess returns for portfolio management strategies in financial markets.
  • Consistent positive excess returns indicate that a portfolio manager or investment strategy is adding value beyond what could be achieved through passive investing. This can have significant implications for portfolio management strategies as it suggests that active management may justify its fees and efforts through superior performance. Moreover, if certain strategies consistently generate excess returns, they may become highly sought after, potentially leading to market adjustments that could impact future returns.

Related terms

Alpha: Alpha represents the measure of an investment's performance relative to a market index, indicating the excess return generated by an investment strategy.

Sharpe Ratio: The Sharpe Ratio is a measure used to evaluate the risk-adjusted return of an investment, calculated by dividing the excess return by the standard deviation of the investment's returns.

Risk Premium: Risk premium is the additional return an investor requires for taking on the extra risk of an investment compared to a risk-free asset.