Event Study

An event study refers to a statistical analysis examining a specific event's impact on an underlying asset or instrument. The primary goal is to understand how certain events are likely to affect a company's stock in the future.

In empirical analysis, the event study methodology is a powerful tool, providing insights into reactions to market events on a company's operations and their impact on future profits. However, the basic assumptions of the event study model can be unclear at times.

An event study is a statistical method that evaluates market reactions to company-related news. It is also known as "event-history analysis," although this term is more commonly associated with statistical survival analysis. This tool helps understand the consequences of a particular event, such as a company planning to enter into a merger with another firm, impacting the company's share value.

Event studies have a rich historical background, with one of the earliest published works attributed to James Dolley in 1933. While economists Ray Ball and Philip Brown are recognized contributors, the foundations of event study methodology were laid by Eugene Fama, Paul Cootner, and others in the field of finance.

Event study methodology is typically divided into market efficiency, information impact, and group segregating study. The market efficiency group focuses on calculating the accuracy and entry of market news. The information impact group assesses how a company's stocks react to this news. Lastly, the group segregating study calculates abnormal stock returns by deducting normal returns from actual ones. This process involves several steps and methods that can simplify the analysis.

The application of event studies is visible in corporate finance, where various events such as market information, mergers and acquisitions, Initial Public Offerings (IPO), stock splits, as well as the release of audit reports, financial statements, insider trading, and changes in macroeconomic policies can impact stock prices.

Let us look at the examples of event study analysis to comprehend the concept better:

Example #1

Suppose a company releases its quarterly earnings report, revealing better-than-expected profits. Researchers would analyze the stock prices around the announcement date to understand how investors react to this new information. By comparing the actual stock prices with what was expected or with a benchmark index, the event study helps gauge the immediate impact of the earnings announcement on the company's valuation and investor sentiment.

Example #2

Consider a scenario where a country implements a new tax policy. Researchers would analyze economic indicators such as gross domestic product (GDP) growth, employment rates, and investment levels around the time of the policy announcement and implementation. This event study would provide insights into how the market and economy respond to policy changes, helping policymakers and analysts understand the effectiveness and consequences of the introduced economic measures.

Various micro and macro factors can influence stocks, but their effects become evident when comparing pre and post-event conditions. Let's analyze the event study model through the following graph:

The graph depicts a timeline illustrating the period surrounding the event. In this case, May marks the event date when the news is released. The period from January to April-end represents the estimation period or the time before the event, while the timeline from June to October signifies the post-event window.

Before the Event: Investors assume existing trends will persist during the estimation period. However, a significant shift occurred in mid-April when the company announced a major merger with another firm, altering the anticipated trend.

After The Event: The market responded to the merger following the news release. Contrary to the pre-event assumption, where the public expected the market to follow the "Grey-line" without news, the stock actually followed the "Black-line." In this case, the market exhibited a reverse (negative) reaction instead of the anticipated positive one. Various factors, such as one of the firms being heavily in debt, might contribute to this unexpected outcome. Despite the merger being positive news, it negatively impacted the stock, resulting in a bearish trend.

Let us look at the advantages and disadvantages of event study to comprehend the concept better:

Advantages

• Useful in detecting abnormal company results.
• A powerful tool for quickly reflecting on the impact of events.
• Higher accuracy compared to traditional accounting methods.
• Highly effective in technical analysis.
• No bias in estimating the risk-return model.

Disadvantages

• Various assumptions in the study require clarification.
• More comprehensive measures than just abnormal returns are necessary.
• Sample selection can be challenging.
• Event study feasibility depends on achieving market efficiency.
• Incorrect sample choices may lead to false abnormal returns.