Excess Return

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Definition of 'Excess Return'

Excess return is the return on an investment in excess of the risk-free rate. It is a measure of the additional return that an investor earns by taking on more risk. The risk-free rate is the return on an investment that is free of risk, such as a U.S. Treasury bill.

Excess return is calculated by subtracting the risk-free rate from the return on an investment. For example, if an investment has a return of 10% and the risk-free rate is 2%, the excess return is 8%.

Excess return is an important concept in finance because it allows investors to compare the returns of different investments on a risk-adjusted basis. By taking into account the risk-free rate, investors can see how much additional return they are earning for taking on more risk.

There are a number of different ways to calculate excess return. The most common method is to use the capital asset pricing model (CAPM). The CAPM is a model that estimates the expected return of an investment based on its beta, which is a measure of its risk.

The CAPM equation is:

E(R) = Rf + ß(Rm - Rf)

Where:

E(R) is the expected return of the investment

Rf is the risk-free rate

ß is the beta of the investment

Rm is the expected return of the market

The CAPM can be used to calculate the excess return of an investment by subtracting the risk-free rate from the expected return.

Excess return is an important concept for investors because it allows them to compare the returns of different investments on a risk-adjusted basis. By taking into account the risk-free rate, investors can see how much additional return they are earning for taking on more risk.

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