Event Study

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21 Aug, 2024

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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.

What Is An Event Study?

Event study, or event-history analysis, is a methodology adopted where the researchers calculate the impact of a certain event (or news) on stock prices.
The origin of this method dates back to the early 20th century. The researcher James Dolley published the model in 1933.
The different methods for calculating abnormal returns are the market return model, control portfolio, mean return, multiple index market model, and others.
The only difference between event studies and difference in differences is that the latter is used in medical sciences. Thus, it is easy to notice the impact of treatments on groups.

Event Study Method Explained

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.

Examples

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.

Graph

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.

Advantages And Disadvantages

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.

Event Study vs Difference In Differences

The differences between the two are as follows:

Basis	Event Study	Difference In Differences
Meaning	It refers to an empirical method that determines the impact of news on a company's stock.	"Difference in Differences" is a statistical method where the treatment group is compared with the control group.
Purpose	To understand how a specific event impacts the company's share price and trend.	To compare the pre-treatment and post-treatment groups.
Application/ Uses	Mostly used in the finance sector.	"Difference in Differences" finds more applications in medical studies and extends to social sciences, macroeconomics, and other fields.

Frequently Asked Questions (FAQs)

1. What is the importance of event study in economics?

Event studies play a crucial role in economics by providing a quantitative framework to analyze the impact of specific events on financial markets. This methodology helps economists and analysts understand how events influence stock prices, aiding in the assessment of market reactions and the overall economic implications of significant occurrences.

2. What are the steps followed in an event study?

Event studies involve several key steps. Firstly, researchers identify the event and form a sample. Then, they define the event window, estimation period, and event date. Subsequently, normal (expected) returns are estimated and predicted. Abnormal returns are calculated by deducting normal returns from actual ones, and analysts analyze and test how these abnormal returns vary from zero.

3. What are the methods of event study?

Various methods are employed in event studies to calculate abnormal returns. These include the market return model, control portfolio model, mean return model, risk-adjusted return model, and multiple index market model. Each method offers a distinct approach to assessing the impact of events on stock prices, contributing to the versatility of event study methodology in financial analysis.