Every event study represents a joint test of the research hypothesis, the particular model of expected returns used, and theoretical assumptions (Brown and Warner, 1980). When applying the method, these theoretical assumptions must be met by the specific research context. Otherwise, the results of the analysis may be misleading. The three most central theoretical assumption of the event study methodology are:
- The capital market, based on which the stock response is calculated, is efficient. In other words, it is assumed that the stock returns over the event window of a particular event study application, accurately reflect the economic impact of the event
- The event is unexpected and has not yet been factored into the stock price - only then, the abnormal returns in the event window can reflect the market's reaction to the event
- There are no confounding events during the event window, which could be responsible for the stock price change
Depending on the expected return model used, more assumptions need to be met. For the most common model, the market model, for example, the relationship between the stock and the market needs to remain stable throughout the estimation and the event window. Only then, the alpha and beta factors, which were established with a regression analysis during the estimation window, can be reliably used to predict the expected returns during the event window.
Whether an event study yields meaningful results for a certain research context, can therefore typically be assessed with two questions:
- Are the stock price movements subsequent to the event really attributable to the event?
- Is it fair to assume that the relationship between the firm and the reference index has remained stable?
Answering question (1) points the researcher to factors such as the depth of the capital market and its trading volume (i.e., the availability of a large enough number of buyers and sellers), information leakage prior to the event, and confounding events. Answering question (2) relates to whether the chosen reference index is the best correlate to the firm's stock and whether the reference index and the firm have recently not structurally changed.