firm 1 firm 2 time

−1 0 1 −1 0 1

10 Event Studies
Figure 10.1: Event days and windows
Reference: Bodie, Kane, and Marcus (2005) 12.3 or Copeland, Weston, and Shastri
(2005) 11 ably) simple, we “normalize” the time so period 0 is the time of the event. Clearly the
Reference (advanced): Campbell, Lo, and MacKinlay (1997) 4 actual calendar time of the events for assets i and j are likely to differ, but we shift the
More advanced material is denoted by a star ( ). It is not required reading. time line for each asset individually so the time of the event is normalized to zero for
every asset.
10.1 Basic Structure of Event Studies The (cross-sectional) average abnormal return at the event time (time 0) is
Pn
The idea of an event study is to study the effect (on stock prices or returns) of a special uN 0 D .u1;0 C u2;0 C ::: C un;0 / =n D i D1 ui;0 =n: (10.2)
event by using a cross-section of such events. For instance, what is the effect of a stock
To control for information leakage and slow price adjustment, the abnormal return is often
split announcement on the share price? Other events could be debt issues, mergers and
calculated for some time before and after the event: the “event window” (often ˙20 days
acquisitions, earnings announcements, or monetary policy moves.
or so). For lead s (that is, s periods after the event time 0), the cross sectional average
The event is typically assumed to be a discrete variable. For instance, it could be a
abnormal return is
merger or not or if the monetary policy surprise was positive (lower interest than expected)
Pn
or not. The basic approach is then to study what happens to the returns of those assets uN s D .u1;s C u2;s C ::: C un;s / =n D i D1 ui;s =n: (10.3)
that have such an event.
Only news should move the asset price, so it is often necessary to explicitly model For instance, uN 2 is the average abnormal return two days after the event, and uN 1 is for
the previous expectations to define the event. For earnings, the event is typically taken to one day before the event.
be the earnings announcement minus (some average of) analysts’ forecast. Similarly, for The cumulative abnormal return (CAR) of asset i is simply the sum of the abnormal
monetary policy moves, the event could be specified as the interest rate decision minus return in (10.1) over some period around the event. It is often calculated from the be-
previous forward rates (as a measure of previous expectations). ginning of the event window. For instance, if the event window starts at w, then the
The abnormal return of asset i in period t is q-period (day?) car for asset i is

ui;t D Ri;t normal

Ri;t ; (10.1) cari;q D ui; w C ui; wC1 C : : : C ui; wCq 1 : (10.4)

where Rit is the actual return and the last term is the normal return (which may differ
across assets and time). The definition of the normal return is discussed in detail in Section
10.2. These returns could be nominal returns, but more likely (at least for slightly longer
horizons) real returns or excess returns.
Suppose we have a sample of n such events (“assets”). To keep the notation (reason-
The cross sectional average of the q-period car is

P
carq D car1;q C car2;q C ::: C carn;q =n D niD1 cari;q =n: (10.5)
Example 10.1 (Abnormal returns for ˙ day around event, two firms) Suppose there are
two firms and the event window contains ˙1 day around the event day, and that the

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abnormal returns (in percent) are
firm i time
Time Firm 1 Firm 2 Cross-sectional Average
estimation window event window
1 0:2 0:1 0:05 (for normal return)
0 1:0 2:0 1:5
1 0:1 0:3 0:2
Figure 10.2: Event and estimation windows
We have the following cumulative returns
with the actual market return as ˛O i C ˇOi Rm;t , so the the abnormal return becomes "Oit .
Time Firm 1 Firm 2 Cross-sectional Average
Recently, the market model has increasingly been replaced by a multi-factor model
1 0:2 0:1 0:05
which uses several regressors instead of only the market return. For instance, Fama and
0 1:2 1:9 1:55
French (1993) argue that (10.7) needs to be augmented by a portfolio that captures the
1 1:3 2:2 1:75
different returns of small and large firms and also by a portfolio that captures the different
returns of firms with high and low book-to-market ratios.
10.2 Models of Normal Returns
Finally, yet another approach is to construct a normal return as the actual return on
This section summarizes the most common ways of calculating the normal return in assets which are very similar to the asset with an event. For instance, if asset i is a
(10.1). The parameters in these models are typically estimated on a recent sample, the small manufacturing firm (with an event), then the normal return could be calculated as
“estimation window,” that ends before the event window. In this way, the estimated be- the actual return for other small manufacturing firms (without events). In this case, the
haviour of the normal return should be unaffected by the event. It is almost always as- abnormal return becomes the difference between the actual return and the return on the
sumed that the event is exogenous in the sense that it is not due to the movements in the matching portfolio. This type of matching portfolio is becoming increasingly popular.
asset price during either the estimation window or the event window. This allows us to All the methods discussed here try to take into account the risk premium on the asset.
get a clean estimate of the normal return. It is captured by the mean in the constant mean mode, the beta in the market model, and
The constant mean return model assumes that the return of asset i fluctuates randomly by the way the matching portfolio is constructed. However, sometimes there is no data
around some mean i in the estimation window, for instance at IPO’s since there is then no return data before
the event date. The typical approach is then to use the actual market return as the normal
Ri;t D i C i;t with E.i;t / D Cov.i;t ; i;t s / D 0: (10.6) return—that is, to use (10.7) but assuming that ˛i D 0 and ˇi D 1. Clearly, this does not
account for the risk premium on asset i , and is therefore a fairly rough guide.
This mean is estimated by the sample average (during the estimation window). The nor-
Apart from accounting for the risk premium, does the choice of the model of the
mal return in (10.1) is then the estimated mean. O i so the abnormal return becomes Oi;t .
normal return matter a lot? Yes, but only if the model produces a higher coefficient of
The market model is a linear regression of the return of asset i on the market return
determination (R2 ) than competing models. In that case, the variance of the abnormal
Ri;t D ˛i C ˇi Rm;t C "it with E."i;t / D Cov."i;t ; "i;t s / D Cov."i;t ; Rm;t / D 0: (10.7) return is smaller for the market model which the test more precise (see Section 10.3 for
a discussion of how the variance of the abnormal return affects the variance of the test
Notice that we typically do not impose the CAPM restrictions on the intercept in (10.7). statistic). To illustrate this, consider the market model (10.7). Under the null hypothesis
The normal return in (10.1) is then calculated by combining the regression coefficients that the event has no effect on the return, the abnormal return would be just the residual

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in the regression (10.7). It has the variance (assuming we know the model parameters)
Var.ui;t / D Var."i t / D .1 R2 / Var.Ri;t /; (10.8)
where R2 is the coefficient of determination of the regression (10.7).
Proof. (of (10.8)) From (10.7) we have
Var.Ri;t / D ˇi2 Var.Rm;t / C Var."it /:
We therefore get
Var."i t / D Var.Ri;t / ˇi2 Var.Rm;t /
D Var.Ri;t / Cov.Ri;t ; Rm;t /2 = Var.Rm;t /
D Var.Ri;t / Corr.Ri;t ; Rm;t /2 Var.Ri;t /
D .1 R2 / Var.Ri;t /:
The second equality follows from the fact that ˇi D Cov.Ri;t ; Rm;t /= Var.Rm;t /, the
third equality from multiplying and dividing the last term by Var.Ri;t / and using the
definition of the correlation, and the fourth equality from the fact that the coefficient
of determination in a simple regression equals the squared correlation of the dependent
variable and the regressor.
This variance is crucial for testing the hypothesis of no abnormal returns: the smaller
is the variance, the easier it is to reject a false null hypothesis (see Section 10.3). The
constant mean model has R2 D 0, so the market model could potentially give a much
smaller variance. If the market model has R2 D 0:75, then the standard deviation of
the abnormal return is only half that of the constant mean model. More realistically,
R2 might be 0.43 (or less), so the market model gives a 25% decrease in the standard
deviation, which is not a whole lot. Experience with multi-factor models also suggest that
they give relatively small improvements of the R2 compared to the market model. For
these reasons, and for reasons of convenience, the market model is still the dominating
model of normal returns.
High frequency data can be very helpful, provided the time of the event is known.
High frequency data effectively allows us to decrease the volatility of the abnormal return
since it filters out irrelevant (for the event study) shocks to the return while still capturing
the effect of the event.
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10.3 Testing the Abnormal Return
In testing if the abnormal return is different from zero, there are two sources of sampling
uncertainty. First, the parameters of the normal return are uncertain. Second, even if
we knew the normal return for sure, the actual returns are random variables—and they
will always deviate from their population mean in any finite sample. The first source
of uncertainty is likely to be much smaller than the second—provided the estimation
window is much longer than the event window. This is the typical situation, so the rest of
the discussion will focus on the second source of uncertainty.
It is typically assumed that the abnormal returns are uncorrelated across time and
across assets. The first assumption is motivated by the very low autocorrelation of returns.
The second assumption makes a lot of sense if the events are not overlapping in time, so
that the event of assets i and j happen at different (calendar) times. In contrast, if the
events happen at the same time, the cross-correlation must be handled somehow. This is,
for instance, the case if the events are macroeconomic announcements or monetary policy
moves. An easy way to handle such synchronized events is to form portfolios of those
assets that share the event time—and then only use portfolios with non-overlapping events
in the cross-sectional study. For the rest of this section we assume no autocorrelation or
cross correlation.
Let i2 D Var.ui;t / be the variance of the abnormal return of asset i. The variance of
the cross-sectional (across the n assets) average, uN s in (10.3), is then

P
Var.uN s / D 12 C 22 C ::: C n2 =n2 D niD1 i2 =n2 ; (10.9)
since all covariances are assumed to be zero. In a large sample (where the asymptotic
normality of a sample average starts to kick in), we can therefore use a t-test since
uN s = Std.uN s / !d N.0; 1/: (10.10)
The cumulative abnormal return over q period, cari;q , can also be tested with a t-test.
Since the returns are assumed to have no autocorrelation the variance of the cari;q
Var.cari;q / D qi2 : (10.11)
This variance is increasing in q since we are considering cumulative returns (not the time
165
average of returns). Similarly, the variances for the cumulative abnormal returns we have
The cross-sectional average cari;q is then (similarly to (10.9))
Time Firm 1 Firm 2 Cross-sectional Average

Pn
Var.carq / D q12 C q22 C ::: C qn2 2
=n D q 2 2
i D1 i =n ; (10.12) 1 2 0:5 0:4
0 8:5 6:7 9:8
if the abnormal returns are uncorrelated across time and assets. 1 7:5 6:4 9:0
Figures 4.2a–b in Campbell, Lo, and MacKinlay (1997) provide a nice example of an
event study (based on the effect of earnings announcements). (I have not double checked the calculations...)

Example 10.2 (Variances of abnormal returns) If the standard deviations of the daily 10.4 Quantitative Events
abnormal returns of the two firms in Example 10.1 are 1 D 0:1 and and 2 D 0:2, then
we have the following variances for the abnormal returns at different days Some events are not easily classified as discrete variables. For instance, the effect of
positive earnings surprise is likely to depend on how large the surprise is—not just if there
Time Firm 1 Firm 2 Cross-sectional Average

was a positive surprise. This can be studied by regressing the abnormal return (typically
1 0:12 0:22 0:12 C 0:22 =4

the cumulate abnormal return) on the value of the event (xi )
0 0:12 0:22 0:12 C 0:22 =4


1 0:12 0:22 0:12 C 0:22 =4 cari;q D a C bxi C i : (10.13)

Similarly, the variances for the cumulative abnormal returns are The slope coefficient is then a measure of how much the cumulative abnormal return react
Time Firm 1 Firm 2 Cross-sectional Average to a change of one unit of xi .


1 0:12 0:22 0:12 C 0:22 =4


0 2  0:12 2  0:22 2  0:12 C 0:22 =4

Bibliography
1 3  0:12 3  0:22 3  0:12 C 0:22 =4
Bodie, Z., A. Kane, and A. J. Marcus, 2005, Investments, McGraw-Hill, Boston, 6th edn.
Example 10.3 (Tests of abnormal returns) By dividing the numbers in Example 10.1 by
the square root of the numbers in Example 10.2 (that is, the standard deviations) we get Campbell, J. Y., A. W. Lo, and A. C. MacKinlay, 1997, The Econometrics of Financial
the test statistics for the abnormal returns Markets, Princeton University Press, Princeton, New Jersey.

Time Firm 1 Firm 2 Cross-sectional Average Copeland, T. E., J. F. Weston, and K. Shastri, 2005, Financial Theory and Corporate
1 2 0:5 0:4 Policy, Pearson Education, 4 edn.
0 10 10 13
Fama, E. F., and K. R. French, 1993, “Common Risk Factors in the Returns on Stocks
1 1 1:5 1:8
and Bonds,” Journal of Financial Economics, 33, 3–56.

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