Event-study, Kothari & Warner + MacKinlay

Question 1

What is the relationship between event studies and testing market efficiency?

Answer 1

Event studies serve an important purpose in capital market research as a way of testing market efficiency. Systematically nonzero abnormal security returns that persist after a particular type of corporate event are inconsistent with market efficiency. Ac- cordingly, event studies focusing on long-horizons following an event can provide key evidence on market efficiency

Question 2

What does an event study seek to establish?

Answer 2

An event study seeks to establish whether the cross-sectional distribution of returns at the time of an event is abnormal (i.e., systematically different from predicted).

Question 3

What is the typical specific null hypothesis to be tested in event study?

Answer 3

Typically, the specific null hypothesis to be tested is whether the mean abnormal return (sometimes referred to as the average residual, AR) at time t is equal to zero.

Question 4

What is the cumulative average residual method (CAR)?

Answer 4

The cumulative average residual method (CAR) uses as the abnormal performance measure the sum of each month’s average abnormal performance. (abnormal = the difference between actual and expected performance)

Question 5

What is an Type I error in event study?

Answer 5

A Type I error occurs when the null hypothesis is falsely rejected. Aka false positive

Question 6

What is an Type II error in event study?

Answer 6

A Type II error occurs when the null is falsely accepted. (false negative)

Question 7

What does it mean that event study tests are joint tests?

Answer 7

event study tests are joint tests of whether abnormal returns are zero and of whether the assumed model of ex- pected returns (i.e., the CAPM, market model, etc.) is correct. Moreover, an additional set of assumptions concerning the statistical properties of the abnormal return measures must also be correct.

Question 8

What does abnormal return mean?

Answer 8

These are the differences between actual returns (what actually happened) and expected returns (what should have happened based on a model).
Example: If a stock is expected to rise by 2% but rises by 5%, the abnormal return is +3%.

Question 9

What are the two joint tests in event study?

Answer 9

Event studies simultaneously test two things:

1. Are the abnormal returns actually zero?
   This checks if the event had any effect.
   The assumptions about the statistical behavior of abnormal returns must hold true.
2. Is the expected return model correct?
   This means the method used to calculate “expected returns” (e.g., CAPM or market model) needs to work properly. If the model is wrong, the abnormal returns might be misleading.

The model used to calculate expected returns (e.g., CAPM) must be correct.

Question 10

What model can you use pre-event to predict expected market returns?

Answer 10

You use a model (like CAPM) to predict expected returns based on market trends.

Question 11

What is a t-test used for in event study?

Answer 11

A t-test is used to determine if the average abnormal return (across several securities or over time) is significantly different from zero.

Question 12

What are the assumptions for the T-test?

Answer 12

Normal distribution and independence (across time and securities).

Question 13

What can be the problem with small samples in event studies?

Answer 13

When number of observations (stocks or days) is small, you can’t rely on the central limit theorem (which usually helps data behave normally when sample sizes are large).

Question 14

Why do long-horizon event study tests often fail to detect abnormal performance?

Answer 14

because returns become noisier over longer periods.
True effects of an event might get “hidden” by other unrelated market factors.

Short-horizon tests are more robust, meaning they are less affected by the choice of the benchmark model (e.g., CAPM) or assumptions about how returns behave.

Question 15

What are Cross-Sectional tests in event studies?

Answer 15

These tests look at how abnormal returns (unexpected stock price changes) differ between firms.
They analyze whether firm-specific factors (like size, industry, or how closely analysts follow the firm) explain the variation in abnormal returns.

Question 16

Which are the two methods for assessing post-event risk-adjusted performance for long-horizon event studies?

Answer 16

1. Characteristic-based matching approach
2. Calendar-time approach (Jensens Alpha)

Question 17

What is the Characteristic-based matching approach?

Answer 17

Compare the performance of the event firm’s stock to that of similar firms (matched based on characteristics like size, industry, and book-to-market ratio).
Example: If a small tech company announces a merger, you compare its post-event returns to other small tech companies that didn’t have a merger.
Goal: Identify the abnormal performance by seeing how the event firm differs from its peers.

Question 18

What is the BHAR approach?

Answer 18

Characteristic-Based Matching Approach, often referred to as Buy-and-Hold Abnormal Returns (BHAR)

BHAR measures the long-term abnormal returns of firms that experience a particular event (like a merger or stock buyback) compared to firms that don’t.

Question 19

Long-horizon buy-and-hold returns, even after adjusting for the performance of a matched firm (or portfolio), tend to be WHAT skewed?

Answer 19

right skewed

Question 20

What is an event study?

Answer 20

Using financial market data, an event study measures the impact of a specific event on the value of a firm. The usefulness of such a study comes from the fact that, given rationality in the marketplace, the effects of an event will be reflected immediately in security prices.

Question 21

What is the event window?

Answer 21

the period over which the security prices of the firms involved in the event will be examined. often, the period of interest is often expanded to multiple days, including at least the day of the announcement and the day after the announcement. This captures the price effects on announcements which occur after the stock market closes on the announcement day.

Question 22

What is the abnormal return defined as?

Answer 22

the actual ex post return of the security over the event window - the normal return of the firm over the event window

Question 23

What is the normal return defined as?

Answer 23

the expected return without conditioning on the event taking place

Question 24

Which are the two common choices for modeling the normal return?

Answer 24

the constant mean return model (assumes that the mean return of a given security is constant through time)

and the market model (assumes a stable linear relation between the market return and the security return): Uses a stock’s relationship with the market index to predict normal returns. Most commonly used due to its simplicity and effectiveness in reducing noise by accounting for market-wide effects.

Question 25

How can you define the estimation window?

Answer 25

using the period prior to the event window. generally, the event period itself is not included in the estimation period to prevent the event from influencing the normal performance model estimates

Question 26

What is another statistical model to model normal return, besides the market model and the constant mean return?

Answer 26

factor model. they are motivated by the benefits of reducing the variance of the abnormal return by explaining more of the variation in the normal return. the market model is an example of factor model

Question 27

Do event study rely on efficient markets?

Answer 27

Yes, event studies rely on the assumption of efficient markets, where prices fully reflect all available information.

Question 28

What is CAR?

Answer 28

The sum of abnormal returns over the event window to assess the total impact of an event