Lec 4 - Intro to short-term study (2/2)

Question 1

How do we estimate expected returns E(r)?

Answer 1

Market Model
alpha - risk
beta - measures sensitivity of stock return to market return / measures a stock exposure to systematic risk (only systematic)

Question 2

What are the two periods that need to be specified?

Answer 2

Test period (TP) - window where you measure abnormal returns
Estimation period (EP) - period where you estimate the parameters of your model

Question 3

What happens in the Estimation period?

Answer 3

Estimating alpha (hat) & beta (hat) using a regression (in the estimation period)

Question 4

What happens in the Test Period (TP)?

Answer 4

Calculate the expected return and abnoraml return in test period

Question 5

How do we measure abnormal returns?

Answer 5

Abnormal return (ARit) measures abnormal return on a day in the test period

Question 6

What is Cumulative Abnormal Return?

Answer 6

CAR measures the abnormal return over several days (from t1 to t2) in the test period

Question 7

What is the average abnormal return (AARt)?

Answer 7

Average abnormal return on an event day

Question 8

What is Cumulative Average Abnormal Return?

Answer 8

Measures in the period i.e -5 to 0 or 5 and you do the average from the period

Question 9

How do we test the return statistical significance?

Answer 9

Question 10

What is an error term?

Answer 10

Predicition error in the estimation period
By definition, its expected value is 0
By definition, the standard deviation or variance of the error term is no greater than the abnormal return

Question 11

What trade-off is associated with choosing the test period?

Answer 11

Between the power of test and the comprehensiveness of the abnormal return
- shorter TP offers a higher power of test if all else remains equal
- shorter TP may leave out some price reaction, especially when the market isn’t completely efficient
- TP within 1 year is short term
(commonly used test periods are in the screenshot)

Question 12

When should the estimation period be?

Answer 12

Normally before the event - data may not be available (IPOs)
Parameters may change due to the event
An EP after the event is allowed

Question 13

How do you choose a market index?

Answer 13

Theoretically the market index contains all financial assets (CAPM)
- We use FTSE etc

Question 14

Should the market index be equal weighted or value weighted?

Answer 14

If there are many stocks it’s not an issue as no stock dominates the index
Equal weight if there is concern that a few stocks dominate the index

Question 14

What data frequency is used in short-term event study?

Answer 14

Daily returns
Higher power of test

Question 14

What is the data frequency used for long-term event study?

Answer 14

Monthly
Easier to work with
Avoids things such as the bid-ask bounce

Question 15

What is the bid ask bounce?

Answer 15

When the price of stock or asset goes back and forth between the bid and ask price

Question 15

How do we identify day 0 in event study?

Answer 15

Announcement days - the ‘information revelation most intensive’
— Cross reference the press reports to ensure accuracy
— Include more days in the Test Period (-2, +2)

Question 16

What are some other models used for short-term event study?

Answer 16

Mean-adjusted return
Market-adjusted mean

Question 17

What is the mean-adjusted return? What are the strengths and weaknesses?

Answer 17

Strengths:
- Convenient
- Easy to implement

Weaknesses:
- Crude measure of abnormal return
- Risks not considered
- E(r) constant over time in time seires, and differs in cross section

Question 18

What is the market-adjusted return?

Answer 18

Strengths:
- Easy to implement
- Don’t need separate Estimation Period (estimation is performed by observing the market return)

Weaknesses:
- Doesn’t consider risks fully
- Assumes alpha = 0 and beta = 1
- E(r) remains constant in cross section, differs in time series

Question 19

What is CAPM?

Answer 19

• If CAPM is right, alpha should be Insignificantly different from 0
• But we still use non-zero value of alpha to calculate E(r) because alpha and beta are jointly significant

Question 20

What are the strengths and weaknesses of CAPM?

Answer 20

Strengths:
- Relatively easy to implement
- Considers the market risk
Weaknesses:
- Other risks not considered

Question 21

What is Fama-French 3 factor model?

Answer 21

If FF3F is right model, alpha should be insignificantly different from 0
But we still use the non-zero value of alpha to calculate E(r) -> because the other coefficients are jointly significant

Question 22

What are the strengths and weaknesses of FF3F?

Answer 22

Strength:
- Consider more risk factors
- Need to calculate factor returns - aren’t always available