Event Study Analysis

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 Event Study Analysis

 Definition: the event study methodology is used to investigate the effect of

an event on a specific dependent variable. Usually the dependent variable
in event studies is the stock price of the company.
 Example: an event study attempts to measure the valuation effects of a
corporate event, such as a merger or earnings announcement, by examining
the response of the stock price around the announcement of the event.

 One underlying assumption is that the market processes information in an

efficient manner.
– Given that the market is efficient, the effects of the event will be reflected immediately in
the stock prices of the company. This will allow us to observe the economic effect of the
event over a relatively short period.

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Event Study Analysis

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 Event Study Analysis

 The event that affects a firm's valuation may be:

1) within the firm's control, such as the event of the announcement of a stock split.
2) outside the firm's control, such as a macroeconomic announcement that will
affect the firm's future operations in some way.

 Various events have been examined:

–mergers and acquisitions
–earnings announcements
–issues of new debt and equity
–announcements of macroeconomic variables (for example CPI, GDP
announcements)
–IPO‟s
–dividend announcements.

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 Event Study Analysis
 Outline of an event study
Identify the event of interest
Determine the observation windows of estimation, event and post-event
estimation.
We require a measure of the abnormal return in order to evaluate the impact
of the event.
Estimate the normal returns based on the observations of estimation
window. The normal returns are defined as the returns that would be
expected if the event did not take place.
Estimate the abnormal returns based on the observations of the event
window. The abnormal returns are defined as the difference between the
actual returns over the event window and the normal returns over the event
window.
Aggregate abnormal returns over the event window. The abnormal returns
must be aggregated in order to draw conclusions about the event of interest.
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 Event Study Analysis
Timeline
 The time-line for a typical event study is shown below:

• The interval T0-T1 is the estimation period (estimation window)

• The interval T1-T2 is the event window
• Time 0 is the event date in calendar time
• The interval T2-T3 is the post-event window
• There is often a gap between the estimation and event periods

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 Event Study Analysis
 Event definition: we have to first decide on the event that we wish to
investigate, and then collect data of companies that had went through such
an event. Note that the event must be unexpected. Also, we must know the
exact date of the event.
 Data: the data that we need includes the announcement date (eg first
announcement date of a merger and acquisition event), the stock prices of
the company before and after the event (eg -120 to +30 days), and the data
on each of the companies.
• Frequency of the data: we have to decide how fast the information is
incorporated into prices. Researchers usually use daily, weekly or monthly
returns and avoid using annual or high-frequency returns (10-seconds or
hourly returns).
• Horizon of the event study: if markets are efficient, we should consider
short horizons –i.e., a few days. Usually we use a short horizon (from 1-
month before to 1-month after the event).

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 Models for measuring normal
performance
 The returns of a company i can be decomposed as:

Rit  ERit X t  uit

where Xt is the conditioning information at time t, Rit are the actual returns
of the company i, and ERit X t  are the “normal” returns of the company.
 The term uit is called the “abnormal” return because it is assumed that the
unexplained part of the returns is due to some “abnormal” event that is not
captured by the model. Therefore, abnormal returns are defined as the
difference between the actual returns and the expected “normal” returns:

uit  Rit  ERit X t 

• There is an exogenous (unanticipated) shock that affects some stocks.

• We want to compare the returns of those stocks around the announcement
to others that are not affected.
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 Models for measuring normal
performance
 Measurement of “normal” returns: we need a benchmark against which
to judge the impact of returns.

• There is a huge literature on this topic.

• From the CAPM/APT literature, we know that what drives expected stock
returns is not exactly clear.
• This is precisely what we need to do in event studies: We need to specify
expected returns (we just call them “normal” returns).
• If we choose a small event window, we can assume that expected returns
do not change.
• If we choose a larger event estimation window, then the expected returns
will possibly change, which will be a big problem.

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 Models for measuring normal
performance
There are two common choices for modeling the normal return-the
constant mean return model where Xt is a constant, and the market
model where Xt is the market return.

 The constant mean return model, as the name implies, assumes that the
mean return of a given security is constant through time.

 The market model assumes a stable linear relation between the market
return and the security return.

Recent asset pricing advances propose more enhanced statistical models

for the expected returns, such as the CAPM, the APT, and different
multifactor extensions of the CAPM model, such as the 3-factor model of
Fama and French (1993), the 4 factor model of Carhart (1997), etc.
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 Models for measuring normal
performance
Constant mean return model

• The constant mean return model assumes that the mean return of a given
security i is constant through time :

Rit  ERit X t  uit

where ERit X t    ,

Euit   0, and Var uit    2 .

• The simple mean returns model often yields results similar to those of more
sophisticated models
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 Models for measuring normal
performance
Market model

• The market model assumes that there is a stable linear relation between the
market return and the return of security i :

Rit  ERit X t  uit

where ERit X t     Rmt ,

Euit   0, and Var uit    2 .

• Rmt represents the return of the market portfolio, and the model‟s linear
specification follows from an assumed joint normality of returns.

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 Models for measuring normal
performance
Market model

 Usually we use a broad-based stock index as the market portfolio. For

instance we use
 S&P 500 index as a proxy of US stock market portfolio,
 DAX index for Germany,
 FTSE100 for United Kingdom, etc.
 The Market Model improves over the constant mean return model: we
remove from uit changes related to the return on the market portfolio.
• The benefit of using the MM depends on the coefficient of determination of
the regression. A general rule is that the higher the R,2 the greater the power
to detect abnormal performance.

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 Models for measuring normal
performance
Alternative Models for Expected Returns

 CAPM
• For each asset i, the CAPM assumes that asset returns are given by:

ERit X t  R ft   Rmt  R ft 

where Rft is the risk free rate, and Rmt denote the returns of the market
portfolio.

• To implement the CAPM, we estimate the following regression by OLS:

Rit  R ft     Rmt  R ft   uit

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 Models for measuring normal
performance
Alternative Models for Expected Returns

 Fama and French (1993)

• Fama and French extend CAPM by adding two factors:

ERit X t  R ft  1 Rmt  R ft    2 SMLt  3 HMLt

• SML: returns on small (Size) portfolio minus returns on big portfolio

• HML: returns on high (B/M) portfolio minus returns on low portfolio

 Several multi-factor extensions of the CAPM model have been proposed,

for example, a momentum factor (Carhart (1997)), an idiosyncratic
volatility factor (Drew et al. (2004)), liquidity risk factors (Acharya and
Pedersen (2005)), etc.

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 Measurement of Abnormal Returns
Abnormal Returns (ARs)

• The Abnormal returns (AR) are calculated as

ARit  Rit  ERit X t 

• To test whether a single abnormal return is statistically different than zero

(i.e, that an event has no impact on the stock returns) , we use the t-statistic:

ARit
t ~ N (0,1)
Y

where  Y is the standard error of the predicted y-value for each x in the
regression ERit X t  . The t-statistic follows under the null hypothesis the
standard normal distribution.

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 Aggregation of Abnormal Returns
 Usually we aggregate the abnormal returns in order to evaluate whether the
event of interest has some impact on the stock price. The aggregation is
performed along two dimensions -through time and across securities. We
will first consider aggregation through time for an individual security
(stock) and then will consider aggregation both across securities and
through time.
 The cumulative abnormal returns (CAR) during the event window are
calculated as

CARit ;t  K  K ARit k

 CAR is the measure of the total abnormal returns during the event window,
and it is computed as the sum of ARs during the event window.

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 Testing an event with Cumulative Abnormal
Returns
 To test whether a single cumulative abnormal return is statistically different
than zero (i.e, that an event has no impact on the stock returns) , we use the
t-statistic:

CARit ;t  K
t ~ t ( L1  2)
K  Rit

where  R is the standard error of the predicted Rit-value for each Xt in the
regression ERit X t  and K is the number of abnormal returns used in the
it

summation.
 The t-statistic follows under the null hypothesis the Student t distribution
with degrees of freedom L1 – 2, where L1 = T1 – T0 (estimation window
length).

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 Aggregation of Abnormal Returns Across
Securities
 Suppose there are 1,…,N securities. Then we can calculate the cumulative
average abnormal returns:

N
1
CA Rit ;t  K 
N
 CAR
i 1
it ;t  K

 The variance of the cumulative average abnormal returns is the average of

the variances of the cumulative abnormal returns.
 Equivalently, the standard deviation of the cumulative average abnormal
returns is the average of the standard deviations of the cumulative abnormal
returns:

 CA Rit ;t  K    CARit ;t  K    K  Rit

1 N 1 N
N i 1 N i 1

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 Testing an event Across Securities
 To test the null hypothesis that an event conveys information useful for the
valuation of firms, we can use the following t-statistic:

t  CA Rit ;t  K  CA Rit ;t  K  ~ N (0,1)

• This t-statistic is valid for large samples of events.

 For small samples of events, we can use the alternative t-statistic:

1/ 2
 N ( L1  4) 
t  
*
 CA Rit ;t  K ~ N (0,1)
 L1  2 

where L1 = T1 – T0 (estimation window length).

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 Measurement of Abnormal Returns
 There is a second way to aggregate the abnormal returns.

Buy and Hold Abnormal Returns (BHAR)

• The Abnormal returns (AR) are calculated as

ARit  Rit  ERit X t 

while the buy and hold abnormal returns (BHAR) during the event window
are calculated as

BHARit ;t  K  K 1  ARit  k 

• BHAR are geometric sums of the abnormal returns during the event window.

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 Testing an event with Buy and Hold Abnormal
Returns
 To test whether a single BHAR is statistically different than zero (i.e, that
an event has no impact on the stock returns) , we use the t-statistic:

BHARit ;t  K
t ~ t ( L1  2)
K  Rit

where  R is the standard error of the predicted R-value for each x in the
regression ERit X t  and K is the number of abnormal returns used in the
it

calculation of the geometric sum.

 The t-statistic follows under the null hypothesis the Student t distribution
with degrees of freedom L1 – 2, where L1 = T1 – T0 (estimation window
length).

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 Testing an event Across Securities with Buy
and Hold Abnormal Returns
 To test the null hypothesis that an event conveys information useful for the
valuation of firms, we can use the following t-statistic:

t  BHA Rit ;t  K  BHA Rit ;t  K  ~ N (0,1)

1 N
where BHA Rit ;t  K   BHARit ;t  K
N i 1

 BHA Rit ;t  K    BHARit ;t  K    K  Rit

1 N 1 N
and
N i 1 N i 1

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 Examples of Event Study Analysis
 The event study methodology can be used to investigate the valuation
effects of many events such as an earning announcement.

 Thirty US companies have been categorized based on whether they

reported strong profits, normal earnings or a loss in the earnings
announcements.
 The first category is denoted as good-news firms, the second as no-news
firms, and the third as bad-news firms, respectively.
 The market model is used to compute the abnormal returns.
 The abnormal returns of each category are calculated based on a 21 days
event window (21 days before and after the event of the earning
announcement). We also calculated the corresponding CARs.

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 Examples of Event Study Analysis
 The results of the event study indicates that companies which reported
good news showed higher cumulative abnormal returns, especially on the
event day (Day 0).

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 Example of Event Study analysis
 We will evaluate the valuation effects of the dividend initiation on the
stock price of Microsoft.
 Microsoft announced the initiation of a dividend at 16/1/2003
 Although dividend initiations are considered positive news, they get
mixed reactions by the market. This is because they signal to the market
that the firm is entering into a new phase of its lifecycle, going from a
growth firm into a cash cow. Investors who like to invest on growth firms
may react negatively to such news.
 We will perform an event study analysis on the stock price of Microsoft,
where the event of interest will be the date of announcement (16/1/2003) of
the dividend initiation.
 First we collect historical data on the stock price of Microsoft prior to the
event date. We will also collect data for the same time period of the stock
market portfolio, the S&P 500 index, that will be used to calculate the
abnormal returns.

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 Example of Event Study analysis
 The data are daily observations covering the period from 1/1/1990 to
15/5/2017.
 First step is to calculate the returns series. This is done by using the
formula:
Rit  100 * ln Pit Pit 1 

where Pit is the stock price at time t.

 The following picture presents how we calculate returns.

The formula of returns

 We press enter and then we drag down the window until

the end of the sample. We repeat the process for the S&P
500
 Name the new series Rit and Rmt respectively.

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 Example of Event Study analysis
 Choice of the estimation and event window:
 Two observation windows have to be determined in order to conduct the
event study: the estimation window and the event window.
 We choose to examine the valuation effects of the dividend initiation five
days before and after the date of the announcement (16/1/2003)
 Therefore, the event window will cover the period from 9/1/2003 to
23/1/2003, a total of 11 daily return observations.
 Consequently, the estimation window will cover the period from 2/1/1990
to 8/1/2003.

 Estimation of normal returns.

 A basic step is to estimate the market model for the Microsoft stock returns
based on the observations of the estimation window.
 To achieve this task, we import the data into gretl.

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 Example of Event Study analysis
 How we import the data into gretl:
 Drag and drop the excel file into gretl
 Give a time series representation to your data
 Select „time series‟
 Data Frequency: since the observations are daily (5-day) prices and returns,
we click on daily (5-day)
 Insert the first date of the sample (1/1/1990)
 The workfile is ready
 We estimate the market model based on observations of the estimation
window.
 To do so, we select “Sample”, and then “Define Range”
 Determine the range of the estimation window: 2/1/1990 – 8/1/2003

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 Example of Event Study analysis
 Estimate the market model:
 Select “Model”, and then “ordinary least squares”
 Select Rit (i.e, the Microsoft stock returns) as the dependent variable and Rmt (i.e.,
the S&P 500 index returns) as the independent variable.
 Click OK Estimation window length

 The estimated market model for Microsoft stock returns is:

Rit  0.0745  1.3465Rmt  uit

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 Example of Event Study analysis
 Calculate the abnormal returns
 Since we have estimated the intercept (0.0745) and the beta coefficient (1.3465) of
the market model, we are able to compute the expected returns of the stock.
 The abnormal returns are calculated as the difference between the actual returns and
the expected (normal) returns:
ARit  Rit  ERit X t   ARit  Rit  b0  b1Rmt 
 ARit  Rit  0.0745  1.3465Rmt 
ARit  0.196903  0.0745  1.3465 * (0.00108)

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 Example of Event Study analysis
 Calculate the abnormal returns in excel
 We write the estimates of the intercept (i.e., 0.0745), the beta coefficient (i.e.,
1.3465) and the standard error of the regression (i.e., 1.888) on excel.
 Then, we calculate the abnormal returns by subtracting the actual stock returns
(column D) from the expected returns.
 Remember to hold fixed the cells that contain the values of the intercept and the beta coefficient (this
is done by pressing F4 each time). Then drag down the cell to compute the remaining ARs.

ARit  Rit  0.0745  1.3465Rmt 

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 Example of Event Study analysis
 Test whether the abnormal returns are statistically different than zero
 Compute the t-statistic t  ARit  Y for each abnormal return, where  Y is the
standard error of the regression of the market model.
 The standard error of the regression of the market model is 1.88. Therefore, we
divide each element of the 6th column by 1.88
 Then we compare the t-statistic with the critical value of the standard normal
distribution for a specific level of statistical significance.
 For instance, at level 5% the critical value is 1.96. Therefore, we reject the null hypothesis that the
abnormal return is statistically insignificant when t *  1.96
 We find that the abnormal return at 17/1/2003 is statistical significant, thus we find evidence that the
event had an impact on the stock price of Microsoft.
t  0.122754 1.88

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 Example of Event Study analysis
 Calculate the cumulative abnormal returns (CARs).
 It is likely that there will be quite a bit of variation of the returns across the days
within the event window. We may therefore consider computing the time-series
cumulative abnormal return (CAR) over the event window.
 Therefore we calculate the sum of the Abnormal returns over the event window by
using the following formula:

CARit  CARit 1  ARit

CARit  0.191992  0.122754

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 Example of Event Study analysis
 Calculate the cumulative abnormal returns in excel

 The first cell of the CAR column must contain the first abnormal return.
 In the second cell we must the current abnormal return to the previous CAR.
 We press ENTER and then we drag down the cell in order to compute the
remaining CARs within the event window (dates in bold)
CARit  CARit 1  ARit

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 Example of Event Study analysis
 The following graph presents the Cumulative abnormal returns over the
event window.
 It is evident that there is a substantial decrease in the cumulative returns
after the announcement of the dividend initiation (t = 0).
 Therefore, the event of the dividend initiation appears to have a negative
impact on the stock price of Microsoft.

CARs
3

0
CARs

-1 -5 -4 -3 -2 -1 0 1 2 3 4 5

-2

-3

-4

-5

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 Example of Event Study analysis
 Test whether the Cumulative abnormal returns are statistically different than zero
 Compute the t-statistic t  CARit ;t  K K R for each CAR, where  R is the standard
error of the regression of the market model and K is the number of abnormal
returns used in the summation.
 The standard error of the regression of the market model is 1.88, while the number
of ARs used in the calculation of the CARs is shown in column 7.
 The critical value of the t-distribution at level 5% and degrees of freedom ( 3397 –
2 = 3395) is 2.24. We find no statistical significant CARs.
t  0.314746 2 *1.88

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