Market-adjusted and two-factor models - event study, Corporate Finance

Market-Adjusted and Two-Factor Models - Event Study

As mentioned previously, you can use several alternative models to calculate a security's expected return. The market-adjusted model is simplest in design and is often used to get a first impression of stock price movements. When using the market-adjusted model, you calculate the abnormal return by taking the difference between the actual return of the security and the actual return of the market index. Thus there is no need to run OLS regressions to estimate parameters. In fact, all you need is the returns at the time of the event. However, when testing the abnormal returns for statistical significance, you still need to gather returns for the estimation period. The two-factor model compares the returns from the market and the industry. You calculate a stock's expected return using parameters from a regression of the actual returns against the market and industry returns during the estimation period. The industry returns are included primarily to account for industry-specific information in addition to the market- specific information. To calculate the abnormal return you subtract from the actual return the portion that can be explained by the market and the portion that can be explained by the industry. As Brown and Warner (1985) showed, the results in a large sample of events are not especially sensitive to your choice of estimation model. However, if you are dealing with a small sample, you should explore alternative models.

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