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Event Study Assumptions

Every event study represents a joint test of the research hypothesis, the particular model of expected returns used, and the underlying finance theory assumptions. Researchers need to be particularly aware of the latter set of assumptions, as their distinct research contexts may not fulfill these assumptions.

The event  study methodology assumes that capital markets accurately reflect the economic implications that the analyzed event has for the firm in question. In other words, event studies presume market efficiency. Brown and Warner (1980) note on this assumption: "Event studies provide a direct test of market efficiency. Systematically nonzero abnormal security returns which persist after a particular type of event are inconsistent with the hypothesis that security prices adjust quickly to fully reflect new information. In addition, to the extent that the event is unanticipated, the magnitude of abnormal performance at the time the event actually occurs is a measure of the impact of that type of event on the wealth of the firms’ claimholders. Any such abnormal performance is consistent with market efficiency, however, since the abnormal returns would only have been attainable by an investor if the occurrence of the event could have been predicted with certainty." (Ibid.: 205-206)

The applicability of the event study methodology thus depends on how likely one may assume the following two pre-conditions for a distinct research project: (1) Does the stock price of the firm promptly respond to new information released to the capital market? (2) Is it worth presuming that the relationship (expressed in the alpha and beta factors) between the firm and the reference index is stable?

Answering question (1) leads the user of the methodology to consider factors such as depth of the capital market and its trading volume (i.e., the availability of a large enough number of buyers and sellers). Answering question (2) relates to whether the chosen reference index is the best correlate to the firm's stock.