Market Efficiency and Event Studies

Introduction to Capital Market Efficiency

• Capital markets facilitate efficient fund transfers between borrowers and lenders.
• Individuals lend if productive opportunities are limited and wealth is high.
• Individuals borrow when many productive opportunities exist and wealth is low.
• Efficient capital markets are beneficial to both lenders and borrowers, as they enable streamlined fund transfers.

Definition of Market Efficiency

• Market efficiency describes the degree to which prices reflect all relevant information.
• Efficient markets use prices as accurate signals for capital allocation.
• Market efficiency is less restrictive than market perfection.

Types of Market Efficiency

• Weak-form efficiency: Prices fully reflect all past information. No investor can earn abnormal returns using historical price/return data.
• Semi-strong-form efficiency: Prices fully reflect all publicly available information. No investor can earn abnormal returns using publicly available information.
• Strong-form efficiency: Prices reflect all information, including private information. No investor can earn abnormal returns using any information.
• Empirical evidence suggests capital markets are efficient in weak and semi-strong forms.

Value of Information

• In a single-period setting, the value of information depends on decision maker's reaction to the information, the probabilities of possible states of nature, and the utilities associated with different actions, given these states.
• In a multi-period setting, the value of information is similar to the value of real options because of the choice of whether to act immediately or later, based on the information received.
• In an efficient market, the information set used by the market is equal to all relevant information,
• Information structure adds only value if it brings new relevant information, which is not the case in the presence of market efficiency, leading to zero utility gain.

Value of Information and Market Efficiency

• In efficient markets, available information is already reflected in security prices.
• There's no incentive to acquire information because no one can generate abnormal returns.
• Using past prices for trading is likely to yield a zero return in an efficient market. Efficient markets are based on the assumption that all relevant information is already factored into pricing.

Rational Expectations and Market Efficiency

• Several hypotheses explain how decision-making process is reflected in securities.
  • Naive hypothesis: Asset prices are entirely random.
  • Speculative hypothesis: Investment choices are influenced by predicted future actions of other investors.
  • Intrinsic value hypothesis: Pricing is based on anticipated future payouts.
  • Rational expectations hypothesis: Prices are determined by anticipated future payouts and resale value. A rational expectations market is an efficient market.

Market Efficiency and Costly Information

• Arbitrageurs and analysts search for information to profit from price discrepancies. This usually helps drive prices to equilibrium values.
• However, information is typically costly. Therefore, the return net of costs from analysis equals zero (on average).

Event Studies

• Event studies measure the impact of economic events on company equity value.
• Examples of economic events include capital increases, stock splits, investments and financing activities.
• They are valuable tools in studying market efficiency.

Fundamentals of an Event Study

• Event studies rely on semi-strong-form market efficiency to demonstrate that past and public information is reflected in security prices.
• Central to an event study is finding the date when the information about the event reaches the public market.
• The study usually evaluates a substantial number of events to minimize the impact of idiosyncratic (unique) events, to ensure results are relevant and not spurious. Event study analysis can determine whether a price change is caused by the event or other factors.

Normal Return in an Event Study

• Normal return, is calculated through a capital market model (usually a single-factor model).
• The normal return gives a benchmark return by isolating the market-wide effect from the event-specific impact.
• An input is the covariance between the stock and the market portfolio, denoted as β. This represents the sensitivity of the stock's return to movements in the market.

Abnormal Return in an Event Study

• Abnormal Return (AR) is the difference between the observed return and the normal return.
• Cumulative Abnormal Returns (CAR) measures abnormal returns over the entire event window.
• Average Cumulative Abnormal Returns (ACAR) is a measure of the average abnormal returns across multiple events.

Significance Tests for ACAR

• Time-series variance test (often from Brown/Warner): Tests whether the average cumulative abnormal return is statistically different from zero, with the assumption that different returns are unrelated.
• Cross-sectional analysis of variance tests whether the average cumulative abnormal return is different from zero across different securities, while controlling for other factors. A non-parametric test, for example, measures significance without the assumption of normal distribution.
• Appropriate methods may be selected based on whether events of interest are correlated.

Econometric Challenges

• Misspecification of expected returns results in biased estimations of abnormal returns, leading to misleading conclusions about market efficiency.
• Non-random samples of firms can lead to non-normal distribution of returns, potentially leading to incorrect inferences.

Further Reading

• Kothari, S. & Warner, J. (2004).
• MacKinlay, A. (1997).
• CWS (Chapter 10 & 11).