Excess return model

Definition

The excess return model is a valuation approach that determines the value of an investment by calculating the excess returns generated above a benchmark or required rate of return. This model is particularly useful in assessing financial services companies, as it highlights the relationship between risk and return while focusing on the performance that exceeds investor expectations.

5 Must Know Facts For Your Next Test

1. The excess return model is especially relevant for financial institutions, as it assesses how well they generate returns over their cost of capital.
2. This model can help identify the true profitability of an investment by stripping away the noise created by market fluctuations.
3. Investors often use this model to compare the performance of different investments, particularly in volatile markets.
4. The calculation of excess returns involves subtracting the required rate of return from the actual returns generated.
5. Understanding the excess return model aids in making informed decisions regarding investment strategies and risk management.

Review Questions

• How does the excess return model assist in evaluating financial services companies compared to other sectors?
  • The excess return model is particularly valuable in evaluating financial services companies because it focuses on returns generated beyond the cost of capital. This sector often has specific risks and returns associated with it, making it crucial to assess how well these companies perform relative to expectations. By isolating excess returns, investors can gain insights into a company's operational efficiency and overall profitability.
• Discuss how the excess return model relates to risk-adjusted returns in investment decision-making.
  • The excess return model is closely tied to risk-adjusted returns because it emphasizes the importance of understanding how much additional return an investment generates for its level of risk. By comparing excess returns with required rates of return, investors can better evaluate whether an investment justifies its risks. This relationship helps in optimizing portfolios and making more informed choices about where to allocate capital.
• Evaluate how the application of the excess return model can impact strategic decision-making within financial institutions.
  • Applying the excess return model can significantly influence strategic decision-making within financial institutions by providing a clearer picture of performance relative to capital costs. Institutions can use this model to identify areas where they are underperforming or generating exceptional returns, allowing them to adjust their strategies accordingly. Additionally, by focusing on excess returns, financial institutions can enhance their competitive positioning in the market and ensure they are meeting or exceeding investor expectations, leading to better long-term outcomes.

Related terms

Discounted Cash Flow (DCF): A valuation method that estimates the value of an investment based on its expected future cash flows, discounted back to their present value.

Capital Asset Pricing Model (CAPM):

A model that establishes a relationship between the expected return of an asset and its systematic risk, helping investors understand risk-adjusted returns.

Risk-Adjusted Return: A measure of return that considers the level of risk taken to achieve that return, allowing for comparisons across different investments.