Event Studies and Abnormal Returns - Literature review Example

? Literature Review: Event Studies and Abnormal Returns Literature Review Introduction There have been many problems associated with traders on stocks at the time of real investment or business. Event studies are thought to be influential for abnormal returns. This is the fact which traders often give importance to, as they think that event studies have partial role in bringing abnormal returns on regular or periodic investments (Getz, 2012). There is a time when events are fabricated to flourish, which is to secure firm value expected on a certain point of time. This is how stock exchanges role and so as the financial advisors of big multinationals, who see events to be clusters of time or moments. This study will give an analytical review on the relationship of event studies and abnormal returns, projected in the past empirical studies of different companies. How event studies are carried out to generate abnormal returns and what is the role of abnormal returns in creating firms value, will also be elaborated in this study (Getz, 2012). Event An event is a reflection of time or moment projecting a situation where stocks raise or drop, and investors invest or back off (Kritzman, 2003). From marketing or finance perspective, an event is certainly a moment where traders meet traders in order to create a glimpse on the entire stock section. This is to bring investors close to the sellers, in order to generate demand of shares of a particular company. Events could be a merger between two companies to allocate the demand on the stocks list. Events are respective dates or moments in which announcements of mergers are to be made. These are settled to give hype to investors and share holders of the company, which in an overall way raise the demand constraint for the company’s products and services (Kritzman, 2003). Event Studies According to past empirical studies, there are several elements, variables or dimensions of an event study, which marketers often relate to it. The assessment of such constraints or dimensions is said to be called as an event study (Kritzman, 2003). From a financial perspective, an event is fabricated to generate an impact or an influence respectively, for which an event study analyzes the collective impact of that event on the stock exchange and on investors. This is how an event study figures out that how much close the company is to raise its demand on its share holders and what is the right time to publicize such an event. An event study determines the overall effect of an event with respect to its constraints and dimensions (Kritzman, 2003). Once the impact is determined, the strategists are able to adjust changes on its constraints to see how effectively such an event can be applied. For example an event study of an announced merger would be to see the impact of the merger on the two firms’ values collectively. The study will elaborate that whether the merger is beneficial for both firms or not, which is assessed with respect to market requirements and past financial statistics (Kritzman, 2003). According to Mitchell and Netter (1994), an event study is a statistical assessment technique which finds out the influence of mergers, changing interest rates, dividend announcements on the company’s shares on the stock exchange (Bhagat & Romano, 2001). There are two types of information which firms reveal in the form of events, one is the information which relates to firm’s under questioning (announcement of dividends) and second is information which influence the market shares of the company like changing interest rates (Bhagat & Romano, 2001). Abnormal Returns Abnormal returns are returns on investment, which are beyond or less than the expected returns. Abnormal returns can be negative or positive depending on how much actual return are obtained. Abnormal return is the difference between actual returns and expected returns respectively, giving a negative or positive value of a return. From traders’ point of view, abnormal return is an instant return of an event, which incurs for a sudden period of time. It is a return on event studies beyond or less than the expectations depending on how well the event study is applied on a particular market situation (Dwyer, 2001). Abnormal returns are closely related to event studies. Depending on how well events are analyzed, abnormal returns are the outcome of such activities (Dwyer, 2001). Abnormal returns are for sudden period of time setting an instant value of the firm. Positive abnormal returns always bring positive impact for the firms’ value, while negative abnormal returns is a complete sign of loss. In event studies, analyzing abnormal returns is also part of the activity. By the assessment of respective models, event studies are compared with past abnormal returns to bring efficient results on stocks and trades of the company (Dwyer, 2001). Securities Securities are a collection of financial instruments which are one form of assets that can be converted into liquid cash in return (Dimson, 1988). Financial instruments are instruments of cash return, which means that they can be utilized to generate profits in the later aspect of time. From traders’ point of view, securities are all such deposits, which can be transformed into cash or capital in return. From investors point of view it is the investment on stocks that can bring liquid asset or cash flow in return (Dimson, 1988). Portfolios In financial definition, portfolios are a collection of investments made by investors like bonds, funds, direct investments or shares on stocks respectively. Portfolio is a term which is eventually utilized in any sort of event study or analysis (Dimson, 1988). By studying an event, the constraint of portfolio is kept on the highest definition to assess the effective part of the return. In event studies, collection of all such constraints is analyzed by estimating collection of investment made on a particular security (Dimson, 1988). Estimation Period It is the period in which both expected and non expected returns are tested. An event study is always assessed on the basis of a specific period whether days, months or years respectively (Dimson, 1988). Estimation period is the time on which the analyst decides that an event is effective or not. Effectiveness of event is measured with the respect of time it requires to bring parallel returns. Abnormal returns are configured on behalf of periods in which the events are placed. When the strategist place an event, there is a parallel assessment made on the period to judge and decide that which event is more appropriate than another. This is how time or estimation period confronts the ground of placing an event in an event study (Dimson, 1988). Relationship of Event studies and abnormal Returns In the context of past studies and literature review, there is a significant relationship between event analysis and abnormal returns. Abnormal returns are outcomes of how the event is analyzed and assessed respectively, where event studies are methods to comprise a substantial abnormal return. On different occasions of time, event studies are carried out to develop the impact and attain positive abnormal returns. In the correlation of event studies and returns, there are multiple factors involved or intruded which are also to be analyzed in order to bring sufficient results. For carrying out an effective event study, there are different methods prevailing on the field like models or testers which actually give direction or technique to carry out the study retrospectively and substantially. In this study, all such tests will be highlighted to check and compare that which test is the most effective for assessment of an event (Luoma & Pynnonen, 2010). An event study always falls in a hypothesis that there are changes in the firm’s value after applying the event at a certain time. These changes are in the form of abnormal returns. Understanding abnormal is important in drafting an event study, because it is something which sets a direction for carrying out the study. To measure the influence of an event, it is necessary that the strategist has substantial methods to evaluate. Methods could include use of the model which measures regular returns of a certain event (Luoma & Pynnonen, 2010). A comprehensive model is one, which adds all the valuable constraints to draw the right relationship of an event study and abnormal return respectively. The model includes all variables which affect the entire return generating process (Luoma & Pynnonen, 2010). Here is the below equation describing the model of an event study with respect to several constraints: Rt = xt B + FG In the above equation R represents return of security in the specific period t. X is representing the vector of independent variables in time t. F denotes the characteristics of the firm’s internal operation, which put influence on the event and on the entire return generation process (abnormal returns). G is one vector indicating how much F is influential on the event periodically and frequently. G is actually the event indicating the parameters set with the context of firm’s value. This model is applicable in different aspects of time in which the strategists can analyze the influence of an event on returns in different periods of time. By evaluating the results on the equation, the impact of an event would be easily determined expressing that whether the event is suitable for a specific node of time or not (Ziobrowski et al., 2011). Approach of Event Study in Short Horizon From empirical studies there are three major elements that are included in the basic approach of an event study. One is to evaluate entire variables, second estimate errors in the forecast and third is to carry out regression analysis in order to calculate the significance level between the event and abnormal returns (Ziobrowski et al., 2011). For effective event studies, there are mainly two types of tests used, one parametric test and second non-parametric tests respectively. Both parametric and non-parametric tests are highly applicable in the empirical finance section giving the outcome required at the time of disclosure of the event (Seiler, 2000). According to Brown and Warner (1980) study, event studies can be performed in order to calculate monthly abnormal returns. In the context of their study, they proposed three basic methods of calculation. (1) Mean-adjusted returns method, (2) market-adjusted returns method and (3) risk-adjusted returns method. In all the three respective models, expected returns are ones that can be calculated. The study contained 250 samples of events with presumed period of months. For better findings, the study included different percentages of abnormal performances which were from 0, 1,5,15, and 50% respectively. By including all the above constraints, all the three methods were applied to see which method is more effective in calculating the abnormal returns on months (Seiler, 2000). All the three methods came out effective in which the basic mean-adjusted returns method came out to be as effective as others. By applying three of the methods cumulative abnormal returned got also determined, which can be expressed by the following equation: + ARt In the above equation, AR represents abnormal returns while t is denoting the period in which the calculations are made. By applying all the three methods, abnormal returns can be determined on a cumulative basis (Luoma, 2011). “Cumulative abnormal returns are sum of all abnormal returns of a specific period” (Luoma, 2011). In the context of study, it can be said that estimation of cumulative abnormal returns will not be effective on a regular basis like on a daily basis. Cumulative abnormal returns cannot be related to post-events or events are part of other events as they provide results on collective finding rather than providing assessment of one significant event. For better understanding and effective study, the analyst must take into account separate events by estimating their separate abnormal results, apart from calculating collective abnormal returns. Cumulative abnormal returns will provide results on the combined level, which will not give credible conclusions in the results. One need to assess event on isolation basis, as this is how an event can raise its impact on long term abnormal results. Experimental Design of Three Estimation Models According to the research conducted by Center for Research in Security Prices (CRSP) University of Chicago, the Brown and Warner models are adaptable and can be applied on daily abnormal returns calculation (Luoma, 2011). In the study the CRSP estimated that whenever the security is selected, an assumed event date is generated. In this study the period set for estimation was from July 2nd to December 31st. For replacement events got selected one by one with an assumption that all the events occur in equal probability of occurrence in each business date. A period of 250 days was selected in the study to observe the daily returns, out of which 239 days were taken as estimation period while the remaining 11 days were considered as the period of the event. The criteria set for including a security in the sample was that it must have minimum 30 daily returns and with no empty data in the last 20 days of the estimation period. In such proceeding the three respective models of estimation came out on the front. Here are the following three models which can be used for calculating abnormal returns effectively: Mean-Adjusted Return Method = The above equation is a representation of first of Brown and Warner (1980) model, where A.i is the excess return of a particular security at t day period. R.i is the arithmetic return on security i for the day t respectively (Khotari & Warner, 2006). Sum of R.i’ is the average of daily returns on security i. Market Adjusted Returns In the above equation R m.t’ is the return from the market share which is subtracted from return on security in t period. Overall the equation is essential for estimating the excess abnormal return of the event date set before (Khotari & Warner, 2006). OLS Market Model This is the model or ordinary least squares used to estimate the abnormal returns with a subjection to the market index. In the context of this model, the following equation comes into place: In this equation ? and ? are values of ordinary least squares determining the fact that abnormal returns are multiple by ordinary least square values of the estimation period (Khotari & Warner, 2006). Risk Adjustment In the short term event studies, there are relatively less chances of adjusting risk factors. Risk adjustment in short horizon event studies is comparatively low than long horizon event studies. This is because methods adapted in the short terms horizon event studies are straightforward typically covering a specific security, an event or an abnormal return. Missing the overall risk factor, short term event studies are only able to adjust short term risks, specifically those which are associated with one single event or one single abnormal return or security (Dimson, 1988). Approach of Event Study in Long Horizon Apart from estimation of short horizon event studies, there are a couple of literatures indicating that firms need to administrate long horizon event studies. In long horizon, an ideal event study is one which addresses issues of the long term like risk adjustment on a quarterly basis, modelling of returns on the long term, and integration of security based abnormal returns respectively. When all the issues are addressed separately and with a substantial work policy, a firm can improve its methods of tactful event study (Gershgoren et al., 2005). From empirical studies like Ball and Brown (1968) and Basu (1977 and 1983) it can be noted that event studies of long horizon got intensified in that period. As studies suggest that event studies based on long term tactics, market efficiency of a firm is more strengthened as compare to short term strategies. There are different types of announcements that firms include in the long horizon event studies. The long horizon announcements could be like post-earning announcement, announcement of size of the market share or announcement of earnings yield respectively. From past empirical studies and literature, it is evident that abnormal returns relate significantly to long term abnormal performances. It is one major phenomenon which has been seen in the firms of 1980s and 90s respectively. The studies also indicate that long term event studies generate long-term abnormal returns, which are quarterly or per annum outcomes of long term work strategy (Khotari & Warner, 2006). Risk Adjustment In long horizon event studies, calculation of risk is the most essential task to perform as without estimation of risk, a firm cannot reach its abnormal performances on the long term basis. For securing the operation of returns generation, it is necessary that the strategist meet the requirements of risk adjustment in the long horizon. In long horizon risk adjustment is carried out in a confound manner, so that all the constraints are covered up and abnormal returns become possible to achieve on the long term basis (Khotari & Warner, 2006). In long horizon there is less chance of error in abnormal performance calculation, which is relatively high in the small horizon event study. With confound calculation of abnormal performances; the long horizon event studies are able to adjust long term risk factors. This is how risk adjustment in long horizon event study becomes efficient and feasible to retrieve long term abnormal returns (Khotari & Warner, 2006). Surprise Announcement Surprise announcement is a form of earning, profitability or firm value which companies reveal to the market being awaited or under the expectation from the companies. Surprise announcements are done on the basis of event studies performed indoor by the companies. As marketing experts say that it is a form of gift which traders set out to the public in order to attain some cash in return. Surprise announcement can be any form of internal activity that has a direct or indirect influence on the external market. By surprise announcements, all the awaiting groups like share holders, stake holders, investors, or public come close to the policies of the company which has made some revealing (Thaler, 2005). It is often that many public limited or private limited companies come on board to give surprise announcements. Companies like Apple, Samsung, Starbucks, Rockwell Collins Inc. or Microsoft go up and down with their surprise announcements to bring variation in the consumer perception and so as in the brand value status. Companies often give surprise announcements in the form of news like Apple received a new height of sales in iPhone section in the particular period or Rockwell Collins announcing high uncertainty on the coming Friday. Service organizations like Banks also reveal surprise announcements, which are to develop the impact of internal ongoing event study (Thaler, 2005). World Bank often announces changes in interest rates, which is to develop the influence of the loan sanction to different countries which they perform on monthly, quarterly or on an annual basis (Thaler, 2005). Project summary From financial or marketing perspective an event is a moment of decision where traders develop a strategy to strengthen the firm’s value. An event could be a surprise announcement like the announcement of new interest rates, funds, merger of two companies respectively (Dimson, 1988). Firms to develop the highest impact of an event carry out event study in all the effective means. This is to generate the outcome of an event in the form of abnormal returns which could be in the form of cash, capital or retrieved investment. From the past literature and empirical studies, there are different methods of performing effective event study (Ziobrowski et al., 2011). One of the method comprise under the short horizon approach, in which the event is studied on short term basis. The second approach is based on long horizon in which the event is analyzed on the long term tactical basis. A surprise announcement is a form an event which comes when the firm has made effective event study. There are different firms in both public and private sector which carry out event studies and bring them in the form surprise announcements in the right time when the firm’s value is required to be developed (Khotari & Warner, 2006). List of References Bhagat, S. & Romano, R., 2001. Event Studies and the Law: Part II--Empirical Studies and Corporate Law. Research Report. Yale: Yale Law School Yale Law School. Dimson, E., 1988. Stock Market Anomalies. Cambridge: Cambridge University Press. Dwyer, G., 2001. The Use of Event Studies in Finance and Economics. Research Report. Rome: University of Rome. Gershgoren, G., Hughson, E. & Zender, J., 2005. A Simple-But-Powerful Test for Long-Run Event Studies. Research Report. North Carolina: University of North Carolina. Getz, D., 2012. Event Studies. Burlington: Routledge. Khotari, P. & Warner, J., 2006. Econometrics of Event Studies. Research Report. Dartmouth: Center For Corporate Governance. Kritzman, M., 2003. The Portable Financial Analyst: What Practitioners Need to Know. New Jersey: John Wiley & Sons. Luoma, T., 2011. A Sign Test of Cumulative Abnormal Returns in Event Studies Based On GSAR. Research Report. Vaasa: University of Vaasa University of Vaasa. Luoma, T. & Pynnonen, S., 2010. Testing for Cumulative Abnormal Returns in Event Studies with the Rank Test. Research Report. Vaasa: University of Vaasa. Seiler, M., 2000. The Efficacy of Event-Study Methodologies: Measuring Ereit Abnormal Performance. Journal of Financial and Strategic Decisions, 13, pp.102-07. Thaler, R., 2005. Advances in Behavioural Finance, Volume 2. New York: Princeton University Press. Tjurins, R. & Nikitins, A., 2011. An empirical study of abnormal return. Research Report. Aarhus : Aarhus University Aarhus University. Ziobrowski, A., Boyd, J., Cheng, P. & Ziobrowski, B., 2011. Abnormal Returns From the Common Stock Investments of Members of the U.S. HOR. Business and Politics, 13, pp.1-19. Read More