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Econometrics For Finance Chapter 5

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53 views17 pages

Econometrics For Finance Chapter 5

Uploaded by

abrhammengistusecond
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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St.

Mary’s University
Faculty of Business and
Economics
Department of Economics
–Course Name- Econometrics
–Course Code- ECON3112
–Credit Hour- 4
–Instructor Name -Dereje Mengist
• October, 2024

October 9, 2024 Econometric for finance 1


Chapter Five: Event Studies
Outlines of CH 5:
5.1 Event Study Methodology
5.2 Measuring and Estimation of Abnormal Returns
5.3 Testing: Parametric Tests vs non-parametric Test

October 9, 2024 Econometric for finance 2


Introduction
Definition:
Event is the public announcement of a corporate action, such as merger,
a security issues, an earnings announcement, a new investment, a stock
split, a new product launch etc.
• Finance theory suggests that capital markets reflect all available
information about firms in the firms' stock prices.
• Given this basic premise, one can study how a particular event
changes a firm's prospects by quantifying the impact of the event on
the firm's stock.
• Finance scholars have developed the event study methodology to
perform this type of analysis
• Event study: It attempts to measure the valuation effects of a
corporate event by examining the response of the stock return around
the announcement of the event

October 9, 2024 Econometric for finance 3


..cont’d
• In finance, an event study refers to whether or not a statistical relationship exists
in the financial markets between a specific event & a public company's stock
return.

• One underlying assumption is that the market processes information


about the event in an efficient and unbiased manner.

• Thus, we should be able to see the effect of the event on stock return.

October 9, 2024 Econometric for finance 4


..cont’d

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


• Within the firm's control, such as the event of the announcement of a stock
split.
• 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(one company purchases and absorbs the other into its operations)
– earnings announcements
– issues of new debt and equity
– announcements of macroeconomic variables

– dividend announcements, etc.


5.1 Event Study Methodology
The steps for an event study are as follows:
• Event Definition: define the event of interest & the period of w/c the impact on
security prices will be examined

• Firm Selection Criteria: availability of data, characteristics of data sample.

• Measuring Normal and Abnormal Return: actual return minus normal


return(estimated return as if the event not occurred)

• Estimation Procedure: estimate model parameters over the estimation period , usually
prior to event

• Testing Procedure: define the null hypothesis, aggregation of the AR’s, statistical tests

• Empirical Results: diagnostics, sample size and any possible violations of assumptions

• Interpretation and conclusion: economic insights into the event and its impact on firm
value, competing explanations etc.

October 9, 2024 Econometric for finance 6


..cont’d
• Return event studies quantify an event's economic impact in abnormal returns.

• Abnormal returns is equal to actual return –normal return.

where normal return is return before event occur, while the actual returns can be
empirically observed.

• For this, the event study methodology makes use of expected return models,

which are also common to other areas of Finance research.

October 9, 2024 Econometric for finance 7


5.2. Measuring and Estimation of Abnormal Returns
A) Models for measuring abnormal performance

• We can always decompose a return as:


𝑅𝑖,𝑡 = 𝐸 𝑅𝑖,𝑡 ห𝑋𝑡 + 𝜀𝑖,𝑡

In event studies, 𝑋𝑡 is the conditioning information at time t,


𝐸 𝑅𝑖,𝑡 ห𝑋𝑡 𝑖𝑠 expected returns (“normal” returns), 𝜀𝑖,𝑡 is called the “abnormal” return.

Question: Why abnormal?

• It is assumed that the unexplained part is due to some “abnormal” event that
is not captured by the model.

• In a sense, we want to get close to a natural experiment.


– 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
October 9, 2024 Econometric for finance 8
..cont’d
• Statistical models of returns are derived purely from
statistical assumptions about the behavior of returns -i.e.,
multivariate normality.
• Multivariate normality produces two popular models:
– 1) constant mean return model and
– 2) the market model
Note: If normality is incorrect, we still have a least squared
interpretation for the estimates
– If the restrictions are true, we can calculate more precise
measures of abnormal returns.

October 9, 2024 Econometric for finance 9


..cont’d
• Two Statistical Models: Constant mean return model &Market model (MM).
I. Constant mean return model
• For each asset i, the constant mean return model assumes that asset returns are given by:

𝑹𝒊,𝒕 = 𝑬 𝑹𝒊,𝒕 ห𝑿𝒕 + 𝜺𝒊,𝒕


2
where 𝐸 𝑅𝑖,𝑡 ห𝑋𝑡 = 𝜇, 𝐸 𝜀𝑖,𝑡 = 0, and 𝑣𝑎𝑟 𝜀𝑖,𝑡 = 𝜎𝑖,𝑡
II. Market model (MM) (the most popular in practice)
• For each asset i, the constant mean return model assumes that asset returns are given by:

𝑹𝒊,𝒕 = 𝑬 𝑹𝒊,𝒕 ห𝑿𝒕 + 𝜺𝒊,𝒕


2
where 𝐸 𝑅𝑖,𝑡 ห𝑋𝑡 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑚,𝑡 , 𝐸 𝜀𝑖,𝑡 = 0, and 𝑣𝑎𝑟 𝜀𝑖,𝑡 = 𝜎𝑖,𝑡

• In this model 𝑅𝑚,𝑡 is the return on the market portfolio( e.g. stock index).
When 𝛽𝑖 = 0, we have the constant mean return model.
• The MM improves over the constant mean return model: we remove from 𝜺𝒊,𝒕 changes related to
the return on the market portfolio.
• If 𝑹𝟐 is higher , the greater the power MMto detect abnormal performance
October 9, 2024 Econometric for finance 10
..cont’d
B) Estimation of Abnormal Returns
• Here we use two a commonly used abnormal returns estimation methods:

1. Cumulated Abnormal Returns (CARs)

𝐴𝑅𝑖,𝑡 = 𝑅𝑖,𝑡 − 𝐸 𝑅𝑖,𝑡 ห𝑋𝑡


𝑖
𝐶𝐴𝑅𝑡,𝑡+𝑘 = ෍ 𝐴𝑅𝑖,𝑡+𝑘
𝑘
Note: CARs are like prices -they are prices if we have log returns
• If we fix K; we can compute the variance of the CAR. Then, under certain conditions
𝑖 2
𝐶𝐴𝑅𝑡,𝑡+𝑘 = ~𝑁(0, 𝜎𝑡,𝑡+𝑘 )
• The sample mean of CAR is defined by
𝑁𝑖
𝑖 1 𝑛
𝐶𝐴𝑅𝑡,𝑡+𝑘 = ෍ 𝐶𝐴𝑅𝑡,𝑡+𝑘
𝑁𝑖
𝑛=1
• The sampling distribution of the mean of CAR is defined by
𝑁𝑖
𝑖 1 2
𝐶𝐴𝑅𝑡,𝑡+𝑘 = ~𝑁 0, 2 ෍ 𝜎𝑡,𝑡+𝑘
𝑁𝑖,
𝑛=1
October 9, 2024 Econometric for finance 11
October 9, 2024 Econometric for finance 12
3) Testing: Parametric Tests vs non-Parametric Test

Parametric model vs non- Parametric Econometric model:


• Parametric model: the joint probability distribution between the
dependent variable /vector Y and the explicative variables X is
fully characterized by a set of parameters:
𝑌 = 𝑓 𝑋; 𝛽 + 𝜀
where link function f (.) is assumed to be known.
• Non parametric and semi-parametric models: the link function can
not be described using a finite number of parameters. The link
function is assumed to be unknown (no probability distribution)
and has to be estimated.

October 9, 2024 Econometric for finance 13


..cont’d

• Null Hypothesis: Event has no impact on returns –i.e., no abnormal mean returns, unusual
return volatility, etc.

• The focus is usually on mean returns

I. Parametric Test.

• Traditional t-statistics (or variations of them) are used:

𝑖
𝐶𝐴𝑅𝑡,𝑡+𝑘
𝑡𝐶𝐴𝑅 =𝜎
𝐶𝐴𝑅𝑖𝜏
൘ 𝑛

𝐵𝐻𝐴𝑅𝑖,𝜏
𝑡𝐵𝐻𝐴𝑅 = 𝜎
𝐵𝐻𝐴𝑅𝑖𝜏
൘ 𝑛
October 9, 2024 Econometric for finance 14
Appealing to a CLT, a standard normal is used for both tests.
..cont’d
II. Non-Parametric Tests

• Nonparametric statistics is the type of statistics that is not restricted


by assumptions concerning the nature of the population from which a
sample is drawn.

• Advantage: Free of specific assumptions about return distribution

• Popular Tests: Sign Test (assumes symmetry in returns) and Rank


Test
(allows for non-symmetry in returns).

• Usually, non-parametric tests are used as a check of the parametric


tests.
October 9, 2024 Econometric for finance 15
..cont’d

Econometric Problems
There are many econometric problems in event studies.
The problems can be divided into two categories:
• Misspecifications of expected returns (wrong
inference due to bias in the estimates of abnormal
returns
• Non-random sample, leading to non-normal
distributions (wrong inference due to standard error
calculations)
October 9, 2024 Econometric for finance 16
..cont’d

The end

October 9, 2024 Econometric for finance 17

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