EVENT STUDY: A TEST ON

MARKET EFFICIENCY

Samit Paul
IIM, Calcutta
What Is EMH?
 Efficient Market Hypothesis (EMH) has been developed by
Prof. E. Fama.

 Share prices fully reflect all available information and prices

are equal to their intrinsic, or fundamental or fair values

 New information comes into the market and it will be

reflected into share price instantly and constantly

 Since information will come randomly, price will move

randomly around the intrinsic or fair values

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Random Walk with Positive Trend
Security Price

Intrinsic or Fair Value

Price

Time

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EMH classification

 Weak form efficiency

 Semi-strong form efficiency

 Strong form efficiency

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Weak form Efficiency

 Current market price reflects all information of

past history of security price

 It should not be possible to make consistent

excess returns on securities by using the past
history of share price movement

 Information Set  = Past Information

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Semi-strong form Efficiency

 Current prices instantly and fully reflect all past

and publicly available information

 It is not possible to make consistent excess

returns on securities by using publicly available
information

 Information Set  = Past as well as Publicly

available Information

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Strong form Efficiency

 Current market prices instantly and fully reflect

all information (Past, Public and Private)

 Even directors or insider with access to

privileged inside information should not be able
to make consistent excess returns

 Information Sub-Set  = Past, Public and Private

Information

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Three forms of Efficiency

EMH FORM INFORMATION SUB-SET

()

Weak a

Semi-Strong a+b
Strong a+b+c

Where,
a = Past Securities Prices Information
b = Generally Available Public Information
c = Privately Held (Monopolistic or Insider) Information

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Different forms of M.E.

Semistrong Weak Form

Strong Form
Form
Tests of Efficiency

 Weak form Hypothesis: whether it is possible to

earn excess return consistently on the basis of
past information

 Semi-strong form Hypothesis: whether it is

possible to earn excess return consistently on
the basis of publicly available information

 Strong form Hypothesis: whether any type of

investor is able to earn extra returns consistently

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Weak form tests

 The weak-form of efficiency test has also been designated in

the literature as test of ‘Random Walk Hypothesis’ (RWH)

 The applicability of Random Walk Hypothesis implies that

stock prices are independent and one is unable to identify a
pattern
 One way of testing the RWH could be to check for correlation
in increments of prices or increments of log prices (i.e.,
return), which implies that if the increments in prices or
returns are uncorrelated, then the random walk hypothesis
holds and vice versa

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Weak form tests

 Serial Correlation Test

 Ljung Box Statistics

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Semi-strong form tests
Event study

 The idea behind such study is to see how quickly

and accurately news is incorporated into the
share price

 If the EMH holds, then the effect of news will be

immediately and instantaneously incorporated
into the market price of a security which will
jump on the announcement of the new
information to a new fundamental value as
depicted in the following figure

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Semi-strong form tests
Share Price

EMH

News Time
The impact of news according to EMH

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 Semi-strong form tests
Share Price
 If the market is
overreaction inefficient then a
variety of other
EMH scenarios are possible
i.e., there may be
Under reaction
overreaction or under
reaction.

News Time
The impact of news if market is not
efficient

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 Semi-strong form tests
Share Price
 If the market
consistently overreact
overreaction
to new information, it
would pay investors
EMH to go short on stocks
which are affected by
good news, and buy
stocks adversely
affected by bad news.

News Time
The impact of news if market is not
efficient

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 Semi-strong form tests
Share Price
 Conversely, if the
market consistently
under-reacts to news
then it would pay
EMH investors to buy
stocks affected by
Under reaction good news and sell or
go short in stocks
adversely affected by
bad news
Time
The impact of news if market is
not efficient

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Methodology of Event Studies
 Collect a sample of firms that had a surprise
announcement (the event): Announcement of
Stock split or M&A

 Determine the precise day of the announcement

and designate this day as zero

 Define the period to be studied

If we studied 20 days around the event, then we would designate –

10, -9, -8, ………., -1 as the 10 days prior to the event, 0 as the event
day, and +1, +2, …….., +10 as the 10 days after the event.

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Methodology of Event Studies
 For each of the firms in the sample, compute
the return on each of the days being studied.

 Compute the excess return for each of the days

being studied for each firm in the sample.

Actual Return – Expected Rate

Ei,t = Ri,t – E(Ri)

where Ri,t = actual return

and E(Ri)= a + iRm (as per CAPM)

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Methodology of Event Studies
 Compute for each day in the event period the
average excess return for all the firm in the
sample.
m
 Expected Et  E
i 1
i ,t m

 Cumulative Abnormal Return

k

 Expected ( E )
t 1
t

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 Methodology of Event Studies
Cumulative Expected Et

+8
+7
+6
+5
+4
+3
+2
+1
0

-10 -8 -6 -4 -2 0 +2 +4 +6 +8 +10

Days relative to announcement days

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 Methodology of Event Studies
Cumulative Expected Et

+8
+7
+6
+5
+4
+3
+2
+1
0

-10 -8 -6 -4 -2 0 +2 +4 +6 +8 +10

Days relative to announcement days

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Sources of Extra Return
 First, the fact that an important announcement
will take place is often released to the public
prior to the announcement. In an efficient
market this should be reflected in price before
the announcement takes place.
 Firms split their stock generally after a
substantial price rise. Hence, studies of stock
splits will find abnormal returns prior to the
announcement because firms with abnormal
returns are more likely to split their shares.
 Abnormal returns prior to the announcement day
could reflect leakage of the information by those
with access to it
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Event Study Tools
https://eventstudytools.com/

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Event Study Tools
https://eventstudytools.com/

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Event Study Tools
https://eventstudytools.com/

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Event Study Tools
https://eventstudytools.com/

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Event Study Tools
https://eventstudytools.com/

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Event Study Tools
https://eventstudytools.com/

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Strong form Efficiency
Insider Trading
 Director’s/Managers’ Share Purchases.
 One way of testing for strong-form market
efficiency is to look at the effects of share
purchases by directors and managers of
companies, which they run.
 One would expect insiders to purchase shares
before any price rises and sell shares in advance
of price falls.
 If it is found that they earn excess return from
their purchases/sales, it is suggested that
strong-form of market efficiency is rejected.

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