Event study Essay Example | Topics and Well Written Essays - 2000 words

Event study - Essay Example A plausible explanation for these findings is that changes in the optimal dividend and debt levels stem from changes in, expected cash flows, and thus, signal a change in firm value. Efficient Market Hypothesis Researchers have developed a hypothesis known as the Efficient Market Hypothesis (EMH) which states that the market prices reflect all information known to the public. Market react to any new information available in the market immediately as reflected in stock prices rather than gradually adjust it. The term ‘efficient market’ was coined by Eugene Fama in 1965. He described an efficient market as a market where at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. The efficient market prices represent the intrinsic value of the securities. The EMH along with the Random Walk Hypothesis (RW H) flies in the face of Wall Street financial analysts. Financial analysts despise even hearing those terms. This is because these hypotheses suggest that there are no future predictions that can be made about how a market will behave. The suggestion that all the information known about past, present and future events is reflected in the current market prices means that the financial analysts are snake oil salesmen. This is why the EMH is such a controversial hypothesis. Types of Market Efficiency There are three primary categorization of EMH given by Fama (1970) according to the type of information reflected in the stock price – 1. Weak-form efficiency - Share prices reflect all past information and thus, rules out the possibility of predicting future stock prices on the basis of past price data alone. 2. Semi strong-form efficiency - A market is semi strong-form if share prices reflect all the relevant publicly available information. It also includes earnings and dividend a nnouncements, technological breakthroughs, mergers and splits, resignation of directors, and so on. 3. Strong-form efficiency -Market in which share prices reflect not only publicly but also the privately available information. It is assumed that all the information is available to everybody at the same time. Even an insider who has private information about a company cannot earn abnormal profits in strong form of market efficiency. Literature Review Event studies have a long history, including the original stock split event study by Fama, Fisher, Jensen, and Roll (1969). Inconsistent evidence with the efficient market, hypothesis started to accumulate in the late 1970s and early 1980s. Evidence on the post earnings announcement effects (Ball and Brown, 1968, and Jones and Litzenberger, 1970), size effect (Banz, 1981), and earnings yield effect (Basu, 1983) contributed to skepticism for Capital Asset Pricing Model as well as market efficiency. According to the theory of information efficiency, security prices should reflect immediately all information available to the efficient capital market. As positive information and trading cost can be expected, this extreme efficiency hypothesis cannot be held. Fama (1998) in his survey studied the various event studies that intend to validate if the stock prices respond to new information. The events studied include announcements such as earnings surprises, stock splits, dividend, mergers, new