The basic idea and purpose of event studies
Event studies allow you to estimate how asset prices – i.e., prices of stocks, bonds, or CDS – react to announcements of economic events that include new information relevant for the value of the underlying assets. The theoretical framework behind the event study methodology is the theory of efficient capital markets proposed (mainly) by the 2013 Nobel laureate Eugene Fama from the University of Chicago. This theory states that in an efficient capital market all new, price relevant information is immediately included in asset prices. Thus, assuming that the market is efficient and given that no other event occurred on a certain day, the change in an asset’s price as a reaction to a certain event (on that day) can be interpreted as the price effect of that event. As an example, think of a firm that announces to cut its dividend (no other information is released). The firm’s stock price reaction to this announcement can be interpreted as the capital market’s revaluation of the firm including the new information that the firm cuts its dividend.
In general, an event study is a systematic examination of the average impact of a certain event on the price of a certain type of (corporate) asset. In terms of the aforementioned example, it is an examination of the average stock price reaction to the announcement of a dividend cut for a specified sample of firms over a specified period of time. To be interpretable, the examination must exclude all events announced jointly with another piece of new, price relevant information. Because for the sample of firms that announced a certain event one can only observe asset prices that reacted to the event, one needs a counterfactual to interpret the average price reaction to the event. The event study methodology provides a simple solution to that problem. In fact, it is generally assumed that the counterfactual is that no price relevant information would have been released on the event day. Consistent with that assumption, one compares the asset price that occurred as a result of the announcement of the event (the realized price or return) with a hypothetical asset price that would have occurred if no event had been announced (the expected price or return). Several related methods exist for the estimation of the expected price. They all use assets’ price histories to form price expectations. The difference between the realized and the expected asset price, called the abnormal return, can be attributed to the event and be tested for statistical significance. This way, a reliable conclusion about the price impact of specified events can be drawn.
Three forms of price relevant information, and hence three types of event studies, can generally be distinguished. Corporate events constitute the most frequent form of price relevant information. They include, for example, announcements of asset sales, bankruptcies, capital structure changes, CEO sudden deaths, corporate name changes, credit rating changes, dividend changes, earnings warnings, fraudulent financial actions and law suits, mergers and acquisitions (M&A), or spin-offs. Events of this type cannot only affect the asset prices of the firms that announce them, but also the asset prices of the announcing firms’ competitors, customers or suppliers. The second form of price relevant information are announcements of macroeconomic events such as bankruptcies and credit rating changes of countries, announcements made by central banks, or news related to important commodities such as gold and oil. The third form of information that affect prices are regulatory events. Examples include propositions of female quotas for corporate boards, such as the Norwegian gender-mix-law passed in 2003, or the unexpected passage of the UK Bribery Act in 2010.
Event studies constitute an established research method among scholars in accounting, finance, and marketing. One reason for the frequent use of event studies in academic research is that they allow scholars to directly test hypotheses related to firm value. For example, one of the most famous hypotheses that can be tested is Modigliani and Miller’s (1958) hypothesis which states that a firm’s value does not depend on the way a firm is financed. Many academic papers have used the event study methodology to test this hypothesis in the context of debt and equity issues as well as share repurchases. So far, the vast majority of event studies dealing with this and other hypotheses have examined the stock market reaction to corporate events. Yet, in the last decade, two new trends have emerged. On the one hand, scholars have started to examine how corporate debt reacts to certain events. Bond and CDS event studies contribute significantly to a more complete understanding of announcement effects of corporate actions. On the other hand, scholars from the field of legal studies and regulatory authorities have started to use event studies as well. One reason for the increasing number of regulatory event studies is that they enable legal scholars and regulators, such as financial market authorities, to assess the economic impact of laws and changes in regulation and to detect insider trading. The results of event studies are further used by corporations and investment banks. While the latter employ the event study methodology to identify investment opportunities, the former use it to improve their communication with the capital markets or to learn from stock market reactions to events announced by their competitors.