Announcement Date of an Event at 0 Event StudY Basics in Finance How quickly does the market react to new information? +t -t Announcement Date of an Event at 0

Event study analysis Measure both the speed and magnitude of market reaction to a certain event High-frequency (usually, daily) data Ease of use, flexibility Experimental design Pure impact of a given event Try not to permit “other events” from contaminating study Collect a sample of similar events and line them all up on the event date

Reaction to the unexpected good event

Example: How do markets react to corporate financing announcements? Studies show the following announcements are taken to be “good news” causing stock prices to rise, on average: Dividend initiations and increases and share repurchases Leverage increasing transactions (i.e., debt-for- equity swaps) Acquisitions paid for with cash, spin-offs & divestitures Some new debt offerings--especially bank loan renewals Control-concentrating events (new blockholders are announced)

The following announcements received as “bad news” Dividend cuts or suspensions (catastrophic news) Adoption/proposal of anti- takeover defenses Any type of equity financing (including convertibles) Merger financed with new stock issue Any focus-decreasing transactions (diversification strategies)

Methodology: find event to be studied and its announcement date Type of the event Share repurchase or dividend change or announcement of a M&A Date of the event τ=0 Announcement, not the actual payment The event window: several days around the event date Selection of the sample Must be representative No selection biases

Modelling the return generating process Abnormal return: ARi,t = Ri,t – E[Ri,t] Normal return: expected if no event happened Often the market model: Ri,t = αi + βiRM,t + εi,t, The estimation window: period prior to the event window Usually: 250 days or 60 months Event window ( for example: -2 days to +5 days) Aggregating the results over time: Cumulative abnormal return (CAR): CAR[τ-t1: τ+t2] = Σt=τ-t1: τ+t2 ARi,t Find if CARs are Positive, Negative, or Zero.

Strengths of the event study analysis Direct and powerful test of efficiency Shows whether new info is fully and instantaneously incorporated in stock prices Test corporate finance theories Average AR measures market reaction to different types of the events EXAMPLE: Fama Fisher Jensen & Roll tests of stock splits In theory, nothing happens in a stock split Found that those with splits and higher dividends gained, those with no dividend increases stayed flat. Fama, Eugene F., Lawrence Fisher, Michael Jensen and Richard Roll (1969). The adjustment of stock prices to new information, International Economic Review, 10 (1), 1-21.

Stock Splits Eugene Fama, Lawrence Fischer, Michael Jensen, and Richard Roll, 1969, The adjustment of stock prices to new information, International Economic Review 10, 1-22. Abstract: There has been very little actual testing of the speed of adjustment of prices to specific kinds of new information. The prime concern of this paper is to examine the process by which common stock prices adjust to the information (if any) that is implicit in a stock split. In doing so we propose a new event study methodology for measuring the effects of actions and events on security prices. We would expect NO REACTION.

The First Event Study--Stock Splits Average stock price response to the “event” of a stock split. The stock prices are lined up in “event time,” where the month of the stock split is t=0. Because all of the information in the stock split is incorporated into stock prices by the event date, there is on average no tendency for prices to change after the split.

FFJR Findings In a 2/1 stock splits, on average the price drops 50% In a 3/1 stock split, on average the price drops 33% FFJR find that firms that both raise their dividend and have a stock split do show an increase in value. They find that firms that cut their dividend and have a stock split decline in value

Product Recall Events An event study on drug recall announcements or auto recall announcements find negative returns to the drug company or auto company. But even other firms in the industry have negative cumulative abnormal returns. Salience – impact reminds shareholders of recall risks. Lumped Together – customers think all firms are recalled. Marcus, R.D., Swidler, S., and Zivney, T.L., "An Explanation of Why Shareholders' Losses are So Large After Product Recalls," Managerial and Decision Economics, Vol. 8, No. 4, 1987, 295-300.

Werner DeBondt & Richard Thaler Journal of Finance (1985) "Does the stock market overreact?" Test the overreaction hypothesis: Investors pay too much attention to current earnings and punish companies with low P/E ratios Later earnings and prices return to fundamental levels Find that long-term losers (stocks that perform poorly over the prior five-year period) perform better than winners over the subsequent five-year period. Examine long-run performance of winner & loser portfolios formed on the basis of past returns Over different formation and testing periods

Overreaction to Good and Bad News GOOD NEWS BAD NEWS

Data and methodology CARi = S (ARi ) Monthly returns of NYSE common stocks in 1926-1982 (CRSP) Stocks with at least 85 months of data (to exclude small and young firms) Market index: Equal-weighted average return on all CRSP stocks Market-adjusted approach for abnormal returns, AR: ARi = Ri – RM Similar results for CAPM and market model approaches and find the Cumulative AR’s. CARi = S (ARi )

Test procedure Consider 16 non-overlapping 3 year periods: 1/1930-12/1932, …, 1/1978-12/1980 In the beginning of each period, t=0: Rank all stocks on cumulative excess returns during the formation period (past 36 months) Top 35 / top 50 / top deciles stocks = winner portfolio Similarly, for loser portfolio Compute ARs and CARs for the next 36 months: t=1:36 Tested hypotheses: ARL=0, ARW=0, ACARL=ACARW Finding: Losers outperform winners by 24.6% during 36 month testing period Mostly driven by Losers that outperform the market by 19.6%

Potential Returns From An Overreaction Strategy LOSER PORFOLIO WINNER PORTFOLIO

Discuss Ways to Test Market’s Reactions to the following Announcements of Stock Buybacks Announcements of Accounting Irregularities Search news articles How would we test the impact? https://www.apple.com/pr/library/2015/04/27Apple-Expands-Capital-Return-Program-to-200-Billion.html Search news articles How would we test the impact? https://www.wsj.com/articles/u-s-audit-regulator-probing-leak-of-confidential-inspection-information-to-kpmg-1491922950?tesla=y