Empirical Finance

EMH and Event Studies

Abhay Abhyankar

University of Exeter Business School

Abhay Abhyankar (University of Exeter Business

Empirical
School) Finance EMH and Event Studies 1/9
 Returns
• In empirical finance we study asset returns & the relations
between returns not prices.
• This may seem odd because asset pricing models would
have a lot to say about how assets are priced.
• In order to use time series and cross-sectional econometric
methods return processes can be thought as (reasonably!)
stationary unlike price processes.
• We begin with defining a return & look at some “stylized
facts” in financial market data – this is what our models try
to explain and with which we test their predictions.
• A return: Payoff
Rt ≡ t +1
= Gross Return → 1.05 say
Pricet
Net Return=Rt − 1 → .05 or 5% 3
 Basics…
• Compound return over k periods:
1 + R t ( k ) = (1 + R t ) × (1 + R t −1 ) × ...( 1 + R t − k +1 )
Pt Pt−1 Pt− k +1 Pt
= × × ... =
Pt−1 Pt− 2 Pt− k Pt− k

• Annualized returns: (∏ k −1

j=0
(1 + R t − j ) ) n/k
−1

• The log or continuously compounded return:

⎛ P ⎞
ri ≡ ln(1+ Ri ) = ln⎜⎜ t ⎟⎟ = pt − pt −1
⎝ Pt −1 ⎠

• Why log returns?

rt ( k ) = ln(1 + Rt ( k )) = ln ((1 + Rt )× (1 + Rt −1 )×...(1 + Rt − k +1 ) )
= ln(1 + Rt ) + ln(1 + Rt −1 ) + ... ln(1 + Rt − k +1 )
= rt + rt −1 + ... + rt − k +1 4
 Asset Return Distributions
• We make assumptions about the Return Generating
Process.
• Return distribution: often assumed IID (Independently and
Identically Distributed)
ƒ Normal distribution (for convenience).

ƒ Actual Distributions may be “fat tailed”- eg. t-

distribution or possibly Stable (Pareto Levy) Family of

distributions.
• Moments give clues to the shape of distribution: :
ƒ Mean (centre), Variance (Spread).

ƒ Skewness (Symmetry), Kurtosis (Tail Thickness).

ƒ Normal Distribution has Skewness=0 and Kurtosis=3.

5
 Probability Distributions (Normal v. "Fat Tailed" Cauchy)

0.35

0.3

0.25

0.2
Density

Cauchy
Normal
0.15

0.1

0.05

0
-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 6
Variate
Efficient Market Hypothesis

I Bachelier (1900): behaviour of prices is such that speculation should be a fair game;
stock prices follow a random walk.
I Samuelson (1965): In an informationally efficient market price changes must be
unforecastable if they fully incorporate expectations of all market participants.
I Fama (1970): A market in which prices always ‘fully reflect’ all available information
is called ’efficient’.
I Malkiel (1992): A capital market is said to be efficient if security prices would be
unaffected by revealing that information to all participants. Moreover, efficiency with
respect to an information set implies that it is impossible to make economic profits by
trading on the basis of that information set.
Assumptions
1. Market equilibrium can (somehow) be stated in terms of expected returns:

E [pj,t+1 |Ωt ] = (1 + E [rj,t+1 |Ωt ]) pj,t

2. Equilibrium expected returns are projected on the information set Ωt .

Market efficiency rules out the possibility of trading systems based solely on Ωt that have
expected returns in excess of equilibrium returns.

zj,t+1 = rj,t+1 − E [rj,t+1 |Ωt ]

E [mt+1 · zj,t+1 |Ωt ] = 0

I The above suggests three approaches to testing market efficiency:

1. Testing whether prices fully reflect all available information: Empirically

meaningless. No content.
2. By revealing information to market participants and measuring price response:
Empirically unfeasible.
3. By measuring profits generated by trading on information: Testable!!!
Empirical Strategy

The third idea has been used in two main ways:

1. Researchers have studied the profits generated by market professionals. If superior
profits are achieved (after adjusting for risk) then markets cannot be efficient.
I Advantage: Concentrates on actual (real) trading by market participants.
I Disadvantage: One cannot directly observe the information sets used by
managers.
2. One can ask whether hypothetical trading rules based on specified information sets
earn superior returns. This approach requires a clearly defined information set + a
model for risk.
Taxonomy of Information Sets

In order to implement trading based tests an information set must be

defined. The classic taxonomy of information sets is due to Roberts (1967):
1. Weak Form Efficiency: The information set includes only the history of
the prices or returns themselves
2. Semi-Strong Form Efficiency: The information set includes all
information known to all market participants (publicly available
information)
3. Strong Form Efficiency: The information set includes all information
known to any market participant (private information)
Abnormal Returns

I Abnormal returns are defined with respect to a model for risk: random walk, CAPM,
APT, GE, DSGE etc ...
I Abnormal returns are then defined as:
A M
Rt+1 ≡ Rt+1 − Et+1 [Rt+1 ]

I The null of market efficiency is then :

A
H0 : E [mt+1 · Rt+1 |Ωt ] = 0

I If abnormal returns are unforecastable then the hypothesis of market efficiency is not
rejected.
I The older EM literature typically specified constant normal returns, however, risk
premia over the business cycle vary in a predictable way; therefore, predictability can
be accommodated rationally within DSGE models.
Joint Hypothesis Problem

I Tests of market efficiency suffer from serious difficulties in terms of interpreting

results.
I The null of market efficiency contains an implicit joint hypothesis that:
I Markets are efficient
I The correct model for risk has been specified.
I The debate between rational expectations models Vs irrational behavioural models is
captured by the tension implicit in the joint hypothesis problem. Are markets
irrational, or is the test mis-specified?
I Grossman and Stiglitz (1980) show that abnormal returns exist if there are costs of
gathering and processing information. Efficiency tests should therefore really ask
whether deviations from efficiency can survive transaction costs.
Efficient Capital Markets

I Circa 1970 Fama concluded that weak and semi-strong tests of market efficiency held
unambiguously: expected excess returns roughly constant over time.
I In 1991 negative results for market efficiency, the CAPM, and return predictability.
I However, these results were not true rejections of EMH but consequences of the joint
hypothesis problem.
I Need to rethink models for risk / uncertainty: A new taxonomy was needed!
Modern Taxonomy of the Efficient Market Hypothesis

I Tests for predictability: (Weak Form)

I Time-Series
I Cross-Sectional
I Event studies: (Semi-Strong Form)
I Investigate information based studies after release of public information
(see Malkiel’s definition) to test for abnormal returns.
I Since time horizons are so short risk adjustment is unimportant so we
avoid the joint hypothesis problem.
I Tests for private information / superior performance: (Strong Form)
I Mutual fund / Hedge fund performance
I Insider Trading
 Different views on Market Efficiency

• Debate between academics and practitioners whether financial

markets are efficient.

• Debate between academics about behavioural and rational

paradigms.

• Implications for using publicly available data to form buy or sell

recommendations – “searching for undervalued securities is a
wasted effort”.

• Implications for Active v. Passive management of mutual funds.

• Efficient markets is often taken to imply that there should be no

predictability in returns (traditional view). 22
 What is an Event Study ?
• An “event study” is an econometric procedure for isolating the stock
price impact of the event or its impact on firm value.
• An firm-specific event is the public announcement of a voluntary
corporate action
– security sales/repurchases, mergers/acquisitions/takeovers, accounting
disclosures/earnings announcements, bankruptcy/law suits, dividend
announcements, new product launches etc.
• An economy-wide event is also an announcement of exogenous to
the firm:
– Announcement of a new government tax on firms, new laws related to
firms, an oil price rise, a war etc.
• Paper that started it all: Fama, Eugene F. , Lawrence Fisher,
Michael C. Jensen and Richard Roll, 1969, The Adjustment of
Stock Prices to New Information, International Economic Review, 10
(1), 1-21. 24
 Event Studies and Market Efficiency
• An event study is a formal test of semi-strong form
efficiency.
• In semi-strong form efficient market, the stock prices should
fully reflect the impact of any “public” event that affects the
firm’s cash flows.
• Event study methodology is designed to measure the
resulting stock price change – or abnormal return - and to
relate the change to theories explaining the economic value
of the event itself.
• Graphs of Abnormal Returns in event studies also convey
the intuition about the reaction of the market.
• Typically, the reactions are like this: 25
Typical Event Study Result (Takeover Announcements)

Announcement Date

Cumulative Abnormal Return (%)

39
34
29
24
19
14
9
4
-1
-6
-11
-16
Days Relative to Announcement Day

26
Lucca , David O. and Emanuel Moench, 2014, The Pre-FOMC Announcement Drift,
FRB New York WP (forthcoming Journal of Finance)

27
Comment by Cochrane on Lucca and Moench (2014)

The period after a news announcement often features high price

volatility and trading volume, in which markets seem to be fleshing out
what the news announcement actually means for the value of the
security.

For example, Lucca and Moench (2012, Figure 6) show a spike in

stock-index trading volume and price volatility in the hours just after the
Federal Reserve announcements of its interest rate decisions. The
information is perfectly public. But the process of the market digesting
its meaning, aggregating the opinions of its traders, and deciding what
value the stock index should be with the new information, seems to
need actual shares to trade hands. Perhaps the common model of
information— essentially, we all agree on the deck of cards, we just
don’t know which one was picked—is wrong.

28
Sandler, Danielle H. and Ryan Sandler, 2013, Multiple Event Studies in
Public Finance and Labor Economics: A Simulation Study with
Applications, Working Paper, Bureau of Economics, Federal Trade
Commission, USA. 29
 Reaction of Stock Price to New Information
Price ($) Overreaction and
correction

220

180

140 Delayed reaction

Efficient market reaction

100

Days relative
–8 –6 –4 –2 0 +2 +4 +6 +7 to announcement day

Efficient market reaction: Price instantaneously adjusts to and fully

reflects new information.
Delayed reaction: Price partially adjusts to the new information.
Overreaction: The price overadjusts to the new information. 30
Sandler, Danielle H. and Ryan Sandler, 2013, Multiple Event Studies in
Public Finance and Labor Economics: A Simulation Study with Applications,
31
Working Paper, Bureau of Economics, Federal Trade Commission, USA.
 Seven Steps to an Event Study-I
1 Event Definition
– Define the event of interest and the period over which
the impact on security prices will be examined -the
‘event window’.
2 Firm Selection Criteria
– availability of data, characteristics of the data sample.
3 Measuring Normal and Abnormal Returns
– “Actual” return minus a “normal” return (estimated
return as if the event had not occurred).
4 Estimation Procedure
– Estimate model parameters over the estimation period,
usually prior to the event.
32
 Seven Steps to an Event Study-II
5 Testing Procedures
– How to aggregate Abnormal Returns, Define Null
Hypothesis, Statistical tests.
6 Empirical Results
– Diagnostics, sample-related issues like size or
event clustering, any possible violations of
assumptions.
7 Interpretation and Conclusions
– Economic insights into the event and its impact on
firm value, competing explanations etc. 33
 Intuition behind Event Studies-I
(estimation window] (event window] (post-event window]

15 May 2004

T0 T1 T2 T3

• Consider a firm that has, for example, announced the

discovery of a new drug.
• We know the calendar time date of this announcement–
say its 15th May 2004.
• Research Question: What is the impact, on average, on
the stock price of such announcements by drug firms?
• We can collect data on similar announcements by other
firms – suppose we have 2 other firms with these dates:
34
5th February 2004 and 25th June 2004.
 Intuition behind Event Studies-II

Time line for each firm in calendar time

Firm A
Time →

15 May 2004
Firm B

5 February 2004

Firm C

25 June 2004
How do you consider the average
impact of the event on all the firms? 35
 Intuition behind Event Studies-II
Key insight of the Event Study method - change from Calendar Time
to Event Time.
Instead of calendar dates:
use Day 0 to denote the event date
+1,+2,+3 ……for dates after the event
–1,-2, -3…… for dates before the event

14 May 2004 15 May 2004 16 May 2004

For Firm A
Time →
For Firm A
Event Day -1 Day 0 Day +1
Time 36
 Intuition behind Event Studies-III
Now we can align all the firms in event time
regardless of when the event actually occurs in
calendar time
Firm A
Time →
Day 0
Firm B

Day 0

Firm C

Day 0
Advantages? 37
 Event Study Methodology- Some Notation
(estimation window] (event window] (post-event window]

T0 T1 0 T2 T3
τ
• Lets formalize this intuition using notation in Ch. 4. CLM
(1997).
• Use symbol (τ) for returns indexed in event time.
• Let τ=0 be event date.
• The event “window” is defined as τ =T1 +1 to τ =T2
• The event analysis is set around the event day 0, e.g. (0,+1), (-
1,0,1) to study abnormal returns in a small “window” around the
announcement date (date 0). 38
Event Study Basics

I Event dates.
I Size of “event window”:
I Will re‡ect possibility of leakage, precision of event dating.
I Actual return.
I Expected return.
I Measure of variance.
Event Study Basics

I Terminology
I T0 to T1 : pre-event window, length L1
I T1 to T2 : event window, length L2
I T2 to T3 : post-event window, length L3
I τ is the event date.
Event Study Basics

I Assume there are N securities, with vector of returns Rt at each

calendar time t.
I For simplicity assume, Rt N (µt , ∑) independently.
I µt depends on the expected return model. Typically to use
I Constant return model: Rit = µi + εit
I Market model: Rit = αi + βi Rm,t + εit
I FF 3-factor model.
I DGTW-adjusted return.
I If your results depend on the model, that’s not great.
Event Study Basics
I We …rst need to estimate the expected return model.
I Let’s take the market model and write
Rit = αi + βi Rm,t + εit
in vector form as
Ri = Xi θi + εi
0
where Ri = RiT 0+1 RiT 1 is the vector of security returns,
Xi = 1 Rm is a column of 1s and a column of market returns,
0
and θ i = αi βi .
I Good old OLS will give us
1
θbi = Xi0 Xi Xi0 Ri
εbi = Ri Xi θbi
1
b2εi =
σ εbi 0 εbi
L1 2
h i
1
Var θbi = Xi0 Xi σ2εi
Event Study Basics

I Now use the market model to estimate a vector abnormal returns in

the event window.

εbi = Ri Xi θbi = Ri αbi βbi Rm

I Under the null that the pre-event distribution and event window
distribution are the same, we have
h i
E [εbi jXi ] = E Ri Xi θbi jXi
h i
= E Ri Xi θi Xi θbi θi jXi
= 0
Event Study Basics

I Under the null, the variance of the abnormal returns is given by

Vi = Var [εbi jXi ] = E εbi εbi 0 jXi

h ih i0
= E εi Xi θbi θi εi Xi θbi θi jXi
0
= E εi εi 0 + Xi θbi θi θbi θi Xi 0 jXi
1
= Iσ2εi + Xi Xi0 Xi Xi 0 σ2εi

I Two sources of variance:

I The event window returns themselves.
I Estimation error in θbi .
I So under the null, the abnormal returns εbi are distributed N (0, Vi ).
Event Study Basics

I Next we want aggregate the returns in the event window for security i.
I Let CAR (τ 1 , τ 2 ) be the cumulative abnormal return between τ 1 and
τ2 .
I Let γ be a vector with ones in positions corresponding from τ 1 to τ 2 .
I If τ 1 = T1 + 1 and τ 2 = T2 , γ is just a vector of L2 ones.
I Then we have
[ (τ 1 , τ 2 ) = γ0 εbi
CAR

h i
[ (τ 1 , τ 2 ) = Var γ0 εbi
σ2i (τ 1 , τ 2 ) = Var CAR
= γ0 Vi γ

I [ (τ 1 , τ 2 ) are
So under the null, the cumulative abnormal returns CAR
2
distributed N 0, σi (τ 1 , τ 2 ) .
Event Study Basics

I Can also standardize the cumulative abnormal return.

I De…ne the standardized CAR to be
[
\ (τ 1 , τ 2 ) = CAR (τ 1 , τ 2 )
SCAR
b2i (τ 1 , τ 2 )
σ
I This is distributed t with L1 2 degrees of freedom.
I Approximately normal for large pre-event windows (i.e., L1 > 30).
I Length of pre-event window matters because it determines our
b2εi .
estimation error for σ
Event Study Basics

I Finally, we need to aggregate the abnormal returns across securities.

I De…ne average CAR as
1
CAR (τ 1 , τ 2 ) =
N ∑ CAR
[ i (τ 1 , τ 2 )

I This has variance

1
Var CAR (τ 1 , τ 2 ) =
N2 ∑ σb2i (τ1 , τ2 ) .
I Can also work with
1
SCAR (τ 1 , τ 2 ) =
N ∑ SCAR
\ i (τ 1 , τ 2 )

in case you are worried the variance is higher for higher CAR events.
I Not very common.
 Regression-based Event Study-1
• An alternate method to estimating event studies (called a
single pass regression method) used in finance by Eckbo &
Masulis, 1992 and now in many areas in economics is the
following:
• Run the regression R j t = α j + β j R m t + γ j τ D j t + ε j t
• Use a Dummy Variable Dt where = 1 inside the event window,
0 otherwise.
• If ω is the number of days in the window, AR = ω γ.
• The regression produces an estimate of γ and the standard
error of γ, call it σ.
• The statistical significance of the sample average AR can be
inferred using a z-statistic: equals √N times the sample
average value of γ/σ and in large sample z~N(0,1).
50
 Regression-based Event Study-2
• Luca and Moench (2014) study the effect of scheduled FOMC
announcements on stock markets using a dummy-variable
regression model.
rx t = β o + β1 Ιt ( PRE − FOMC ) + β x X t + ε t

where rxt = cum-dividend log excess return on the S&P

Index over the risk-free rate in percentage points.
• Their baseline model: the explanatory variable is a dummy
variable, which is equal to 1 on scheduled pre-FOMC
announcement windows and 0 otherwise and Xt =0 .
• They then use additional control variables denoted by the
vector Xt to include other possible specifications.
51
 Non-parametric tests
• Non-parametric approaches are free of specific
assumptions concerning the distributional properties of
returns.
• Used in conjunction with parametric tests to check the
robustness of conclusions based on parametric tests.
• An Example: Corrado (1989) Signed Rank Test, Null of
abnormal return on event day=0.
• Rank CARs for each stock from 1 to L2 ,let Kiτ be the rank
of the AR of stock i for period τ.
• Test statistic: 1 N ⎛ L2 + 1 ⎞
J C o rra d o =
N
∑i =1
⎜ K i0 −
⎝ 2 ⎟ ÷ s (L 2
⎠
)

2
1 T2
⎛ 1 N
⎛ L2 + 1 ⎞ ⎞
s (L 2 )=
L2
∑ ⎜
τ = T1 + 1 ⎝ N
∑
i =1
K
⎜ iτ
⎝
−
2 ⎟⎟
⎠⎠
52
 References
ƒ Talk by Prof Eugene Fama at the American Finance Association
on the Efficient Markets Hypothesis:

http://johnhcochrane.blogspot.co.uk/2014/02/a-brief-history-of-
efficient-markets.html

ƒ Lucca , David O. and Emanuel Moench, 2014, The Pre-FOMC

Announcement Drift, FRBNY WP (forthcoming Journal of
Finance)

ƒ MacKinlay, A. Craig, Event Studies in Economics and Finance,

Journal of Economic Literature, March 1997, 35 (1), 13-39.

56
 References
ƒ Sandler, Danielle H. and Ryan Sandler, 2013, Multiple Event
Studies in Public Finance and Labor Economics: A Simulation
Study with Applications, Bureau of Economics, Federal Trade
Commission, USA.
ƒ Swanson, Eric, Let’s Twist Again: A High-Frequency Event-
Study Analysis of Operation Twist and Its Implications for QE2,
Brookings Papers on Economic Activity, Spring 2011, pp. 151-
188.
ƒ Cochrane, J., 1999, New Facts in Finance available at:
http://faculty.chicago.booth.edu/john.cochrane
ƒ Michael Brandt: NBER Lectures on Financial Econometrics
(Linear Factor Models and Event Studies)
57
http://www.nber.org/econometrics_minicourse_2010/