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Measuring Changes in Capital Market Security Prices: The Event

Study Methodology

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 REGULAR ARTICLES

Measuring Changes
in Capital Market Security Prices:
The Event Study Methodology
Grant H. Skrepnek
Kenneth A. Lawson

ABSTRACT. The purpose of this paper is to summarize the literature

addressing event study methodologies and to highlight important meth-
odological issues. Six general steps outline defining event dates and
windows, modeling security price returns, estimating model parame-
ters, aggregating abnormal returns, and testing for statistical signifi-
cance. Econometric considerations regarding the nature of security
price returns are also reviewed, including normality, autocorrelation,
heteroscedasticity, and cross-sectional dependence. [Article copies available
for a fee from The Haworth Document Delivery Service: 1-800-342-9678. E-mail
address: <getinfo@haworthpressinc.com> Website: <http://www.HaworthPress.
com> E 2001 by The Haworth Press, Inc. All rights reserved.]

KEYWORDS. Event study, methodology, econometrics, financial eco-

nomics

INTRODUCTION
Event studies are frequently employed in economic, accounting,
and financial research as a method of determining the economic im-

Grant H. Skrepnek, R.Ph., M.S., is a doctoral candidate and Kenneth A. Lawson,

Ph.D., is Associate Professor, both in the Pharmacy Practice and Administration
Division, College of Pharmacy, University of Texas, Austin, TX 78712.
Journal of Research in Pharmaceutical Economics, Vol. 11(1) 2001
E 2001 by The Haworth Press, Inc. All rights reserved. 1
2 JOURNAL OF RESEARCH IN PHARMACEUTICAL ECONOMICS

pact of an event on the security prices of firms. The wide applicability

of event studies is evident from its use in diverse branches of research,
including studies that have measured the impact of mergers and ac-
quisitions, financing decisions, corporate expenditure decisions, regu-
latory changes, and earnings announcements on the value of the firm.
Furthermore, event studies have led to a greater understanding of
capital market efficiency and the nature of competition in the market-
place. The purpose of this paper is to summarize the literature address-
ing event study methodologies and to highlight important method-
ological issues.
In what is often regarded as the first published event study, Dolley
examined changes in security prices following a sample of 95 stock
splits which occurred between 1921 and 1931 (1). Following this
work, event study methodology continued to advance and eventually
resulted in the landmark studies of Fama, Fisher, Jensen, and Roll
(FFJR) and Ball and Brown, which serve as the basis for modern event
study methodology (2, 3). Whereas FFJR conducted a financial study
of capital market efficiency and analyzed security price changes fol-
lowing stock splits, Ball and Brown’s accounting study related stock
market responses to company earnings reports. These studies are re-
ferred to as market efficiency and information content, respectively;
other types of event studies include model evaluation, metric explana-
tion, and methodology studies (4, 5). Following the FFJR and Ball and
Brown studies, researchers have proposed refinements to the method-
ology and have attempted to increase the robustness of statistical tests.
A substantial amount of empirical literature exists that utilizes the
event study methodology, most of which is concentrated in the disci-
pline of corporate finance. Although event studies are typically con-
ducted using marketwide samples, several industry-specific studies
have been completed, including investigations focused on the pharma-
ceutical industry. For example, Skrepnek and Lawson measured the
wealth effects of large horizontal pharmaceutical mergers between
1985 and 1997 (6). The security price returns associated with Food
and Drug Administration decisions were evaluated by Bosch and Lee
(7). Malone, Rascati, and Martin investigated the returns associated
with litigation-related announcements in the pharmaceutical industry
between 1972 and 1993 (8). Changes in Canadian compulsory patent
legislation during 1969 and 1987 were examined by Shapiro and
Switzer (9). Finally, Proctor measured the stock returns associated
 Grant H. Skrepnek and Kenneth A. Lawson 3

with the Drug Price Competition and Patent Term Restoration Act of
1984 (10). Overall, results from event studies have proven instrumen-
tal in understanding the wealth effects associated with the diffusion of
information throughout the capital markets.

STEPS IN CONDUCTING AN EVENT STUDY

The frequently cited simulation studies by Brown and Warner fo-
cused on the nature of event studies using either monthly or daily
stock market data. Dyckman, Philbrick, and Stephan also reported
results from simulations (11-13). The review articles by Bowman,
Peterson, Henderson, Strong, and MacKinlay summarized event study
methodologies (4, 5, 14-16). Furthermore, Schwert provided an early
review of event studies, with a particular emphasis on measuring
regulatory changes (17). Although specific methodologies differ
greatly among studies, researchers generally outline six steps in con-
ducting event studies: (1) define the event date of interest, (2) define
the event window, (3) model the security price returns, (4) estimate
model parameters, (5) calculate and aggregate abnormal returns, and
(6) conduct statistical testing.

Steps One and Two: Define the Event Date of Interest

and the Event Window

The timeline of an event study is comprised of an event date sur-

rounded by various time periods, or windows. The event date is often
referred to as Day 0, which represents the occurrence date of the actual
event that the researcher is investigating (e.g., corporate announce-
ments or regulatory actions). An event window is defined as a period
surrounding the event date; event windows that are subject to empiri-
cal testing may be denoted as test windows. An estimation window is
defined as a period used to estimate parameters of the statistical model
used. It can be a preevent, postevent, or pooled (i.e., pre- and post-)
window. The notation to document an event window is to separate the
beginning and ending points of the time period by a comma, with the
event date defined as day (or month) zero. To illustrate, an event
window extending from 300 days prior to and including an event date
is reported as (−300, 0). Figure 1 shows a graphical representation of
an event study using a preevent estimation period.
4 JOURNAL OF RESEARCH IN PHARMACEUTICAL ECONOMICS

FIGURE 1. Graphical Representation of an Event Study Timeline.

Pre-event Event Post-event

(Estimation) (Test) Window
Window Window
time

t=0
(Event Day Zero)

Adapted from Source: Campbell JY, Lo AW, MacKinlay AC. The Econometrics of financial markets.
Princeton, NJ: Princeton University Press, 1997; 157.

Brown and Warner noted that the power of an event study is depen-
dent upon the researcher’s ability to define an optimally sized event
window, which involves the precise identification of the event date
(11). In choosing an appropriate event date, it should be noted that the
relevant event date of interest may differ from an actual outcome date
of the event. For example, in studying stock market changes, the event
to be studied should be chosen as a point where information first
becomes available to the capital markets. Generally, researchers define
the event date as the first public announcement of the event, which is
often obtained from various sources in the financial press (5, 18). As
event studies rely on the premise of capital market efficiency, any
information contained within a particular event will rapidly appear in
security prices following the first announcement. Common sources of
information useful in identifying an exact event date include the Wall
Street Journal, Reuter Business Report, Dow Jones News Service, and
Associated Press International. Several of these sources may be ob-
tained via the on-line database Lexis-NexisR. Event studies may be
conducted using either daily or monthly stock market data. A common
source for security price data is the Center for Research in Securities
Prices (CRSP) database maintained by the University of Chicago.
Most event studies use event windows that range from 21 to 121
days for daily studies and 25 to 121 months for monthly studies;
researchers often analyze several test windows within these overall
ranges (14). Estimation periods used to calculate the parameters of the
regression model often range from 100 to 300 days for daily studies
 Grant H. Skrepnek and Kenneth A. Lawson 5

and 24 to 60 months for monthly studies (14). Exceeding these guide-

lines is generally not recommended, as the number of observations
used to increase statistical accuracy must be balanced with event win-
dows that have appropriate parameter estimates (15).

Step Three: Model the Security Price Returns

Event studies attempt to measure the differences between expected

security price returns and actual security price returns; this difference
is denoted as an abnormal return. Abnormal returns are synonymous
with excess returns, prediction errors, and residuals (14). Consistent
with statistical theory, the expected value of the residual term in a
regression model is zero. If no abnormal price movement occurs prior
to the event date, the expected abnormal return should fluctuate ran-
domly around zero. Conversely, if there is a market response to the
event, abnormal returns should become measurable on the defined
event date.
Several methods have been developed to estimate abnormal returns.
Strong identified the more common statistical and economic models
used in event studies: (1) mean-adjusted return model, (2) market-
adjusted return model, (3) Capital Asset Pricing Model (CAPM),
(4) matched/control portfolio model, and (5) single-index market
model (SIMM) (15).
The mean-adjusted return model commonly appeared before the
development of more advanced estimation techniques for event stud-
ies. With the mean-adjusted benchmark, security-specific returns are
based upon a constant return which is selected by the researcher. The
model is illustrated as:

(Equation 1)
Rjt = kj + εjt
where Rjt = return for security j during period t
kj = constant return for security j based on historical data
εjt = residual of the equation. (11, 15)

Despite theoretical misgivings, Brown and Warner found that the model
was robust under several conditions and that it outperformed more
advanced methods in certain respects (11, 12). However, this model
6 JOURNAL OF RESEARCH IN PHARMACEUTICAL ECONOMICS

was found to be poorly specified in cases of calendar clustering and it

also produced biased residuals during bear and bull markets (12, 19).
The market-adjusted return model assumes that expected returns
are equal to an expected market return. The benchmark does not
necessarily involve calculating model parameters from an estimation
period. Overall, the model was shown to be less powerful than the
single-index market model benchmark (13). The market-adjusted re-
turn benchmark is represented as:

(Equation 2)
Rjt = Rmt + εjt
where Rjt = return for security j during period t
Rmt = return on the market index during period t
εjt = residual of the equation. (11, 15)

The Capital Asset Pricing Model (CAPM) is a two-factor approach

that includes factors for both security and market risk. The benchmark
takes into account the risk-free rate of return typically defined as the
return on Treasury bills. The CAPM is illustrated as:

Rjt = Rft (1−βj ) + βj Rmt + εjt (Equation 3)

where Rjt = return for security j during period t
Rft = risk-free rate of return during period t
βj = systematic risk of security j to the market
Rmt = return on the market index during period t
εjt = residual of the equation. (11, 15)

The matched/control portfolio model, which is based on the CAPM,

reports differences in returns between a study portfolio and a second
portfolio that is established as a control. Although several different types
of matching may be used, the most common methods are to control with
companies of similar betas or similar industry indexes. Potential strengths
of the control portfolio model include more accurate risk parameter es-
timations, a less critical need for precise estimation period and event date
definitions, and more easily interpretable results (5).
 Grant H. Skrepnek and Kenneth A. Lawson 7

Overall, other procedures have been shown to perform better than

the CAPM and matched/control portfolio benchmarks (11). For exam-
ple, researchers have investigated the restrictions imposed by the
CAPM and have indicated that results may be biased by the model
itself (20). Since the potential biases inherent in the CAPM may be
overcome by using the single-index market model, event studies using
the CAPM have ‘‘almost ceased’’ (16).
The single-index market model (SIMM), or market model, is per-
haps the most commonly employed benchmark in event studies. The
SIMM makes few theoretical assumptions about how security prices
are established other than the stipulation that the systematic risk pa-
rameter, β, is defined as the slope of the regression equation and α is
the intercept that identifies factors other than market influences. The
premise of this model is that a linear relationship exists between a
security’s return and a market index. The model is represented as:

Rjt = αj + βj Rmt + εjt (Equation 4)

where Rjt = dependent variable and the return for security j during period t
αj = intercept of the equation which denotes influences on security
j other than the market
βj = slope coefficient and a measure of the systematic risk of
security j according to the market index
Rmt = return on the market index during period t
εjt = residual of the equation. (15, 21)

The more common market indexes used in event studies include the
Standard and Poor’s 500 (S&P 500), the CRSP value-weighted index,
or the CRSP equally weighted index.
The SIMM is known to produce smaller abnormal return variances
and cross-correlations than several other benchmarks, resulting in a
more powerful statistical test (15, 22). In studying several different
financial models, Brenner indicated that the SIMM performs essential-
ly as well as the other approaches (23). In some instances, however,
multifactor models are advocated over a single-index model. A discus-
sion of multifactor models appears in Sharpe and Sharpe, Alexander,
and Bailey (24, 25).
8 JOURNAL OF RESEARCH IN PHARMACEUTICAL ECONOMICS

Step Four: Estimate Model Parameters

The parameters of the economic or statistical model may be esti-
mated using a pre-, post-, or pooled-event estimation window; a pre-
event estimation window is usually recommended. The rationale for
using a postevent estimation window involves the issue of parameter
shifting, wherein the estimated value for α or β may change as a result
of the event in question. Overall, the presence of a parameter shift may
indicate a change in the sensitivity of the security to the market. In cases
where parameter shifting occurs, support is warranted to include a
postevent period in the estimation procedure (5). The Gujarati tech-
nique is one method of testing for parameter shifting (26).
The ordinary least squares (OLS) method is a common way of deter-
mining model parameters in event studies. Under general conditions,
OLS is regarded as a well-specified procedure for estimating the model
parameters of the SIMM (12, 16). Following OLS estimation of the
model parameters, the linear model assumes the following regarding
the residuals: expected value and mean of zero, constant variance (i.e.,
homoscedastic), lack of autocorrelation, and lack of multicollinearity
with the independent variable, Rmt . Schipper and Thompson presented a
joint generalized least squares (GLS) estimation as an alternative to the
OLS (27). Malatesta, however, reported from a simulation analysis that
GLS was not superior to OLS in many respects (28).
Step Five: Calculate and Aggregate Abnormal Returns
Abnormal returns, as previously mentioned, are defined as the re-
siduals of the security price return model. Once calculated, abnormal
returns are averaged across firms and across time. The average abnor-
mal return during day t is illustrated as:

(Equation 5)

where ARNt = average abnormal return for N securities during day t

N = number of securities in the portfolio

ARjt = abnormal return for security j for day t

Two methods are used to aggregate abnormal returns: the cumu-

lative abnormal return (CAR) and the abnormal performance index
 Grant H. Skrepnek and Kenneth A. Lawson 9

(API). The use of CARs has become established as the most pre-
dominant approach (4). Aggregating averaged abnormal returns
over an extended time period yields the cumulative average abnor-
mal return:

T2
(Equation 6)
T1, T2
t =T1 j =1

where CART1, T2= cumulative average abnormal return for the time period T1 to T2
[e.g., (−5,+5)]
N = number of firms in the portfolio
ARjt = abnormal return for firm j during day t.

Step Six: Conduct Statistical Testing

The earliest event studies employed only graphical methods of re-
porting results. To illustrate, FFJR conducted no tests of statistical
significance; only descriptive statistics were reported (2). Although
graphical methods continue to remain helpful in reporting results,
appropriate statistical tests have become the mainstay in event study
methodology. The choice of statistical test procedures, however, varies
with each study. In general, it is recommended that the researcher
choose the appropriate tests after recognizing the strengths and weak-
nesses of those available.
Several methods are available for the researcher to test statistical
significance of abnormal returns. Earlier studies tested CARs with
standard t tests defined as the abnormal return (or cumulative ab-
normal return) divided by its estimated standard deviation. Recent
practice, however, is to standardize the abnormal returns before
aggregation, thereby changing the definition of the abnormal re-
turn. Although results of event studies may appear as unstandard-
ized abnormal returns, statistical testing is most often conducted
using a different set of test statistics based upon standardized ab-
normal returns.
10 JOURNAL OF RESEARCH IN PHARMACEUTICAL ECONOMICS

A standardization procedure proposed by Patell corrects for differ-

ing residual variances across securities; this procedure was popular-
ized by Dodd and Warner (29, 30). The correction method, termed
the Patell Standardized Residual (PSR), has become the ‘‘conven-
tional test statistic in event study methodology.’’ Examples of event
studies using the PSR include Mikkelson and Partch; Moore, Peter-
son, and Peterson; and Cornett and Tehranian (31-35). In addition to
correcting for differing variances across securities, the PSR adjusts
for the number of observations in the estimation period. Furthermore,
in cases where no event clustering or variance shifting exists, the
PSR has been shown to effectively correct for correlation between
the market return variable, Rmt , and the residual, eit , which may occur
during a bull market (36). The PSR does not account for differing
market variances that may occur between the event period and the
estimation period (5, 29).
Patell Standardized Residual Test Statistic
for a One-Day Event Period
Using the PSR for significance testing, the test statistic for the null
hypothesis that standardized abnormal returns equal zero for any
single day (Ho :SARjt = 0) is illustrated as:

ARjt
SARjt = (Equation 7)
S ARjt

where SARjt = standardized abnormal return for security j during day t

ARjt = abnormal return for security j during day t

SAR = estimated standard deviation of the abnormal returns for

jt
security j during day t. (29, 30)

Each abnormal return, ARjt , is assumed to have a mean of zero and a

constant variance denoted as σ2ARjt . The maximum likelihood estimate
of this variance, S 2ARjt , accounts for variance changes in the prediction
and is illustrated as:
 Grant H. Skrepnek and Kenneth A. Lawson 11

(Equation 8)

where S 2AR = maximum likelihood estimate of variance for security j

jt

S 2AR j = variance of the residuals for security j during the estimation period

, Dj is the number of (nonmissing) trading days

used to estimate the parameters for security j

Rmt = rate of return on the market index during the estimation period

Rm = mean rate of return on the market index during the estimation period

Rmk = rate of return on the market index for day k of the estimation period
(29)

Under the null hypothesis, each SARjt is Student t distributed with

Dj −2 degrees of freedom; with larger samples, the distribution ap-
proaches unit normal.

Patell Standardized Residual Test Statistic

for a Multiday Event Window

Exceeding an interval of two or more trading days (i.e., from day T1

to day T2 ), the test statistic for the null hypothesis that the standardized
cumulative average abnormal return equals
12 JOURNAL OF RESEARCH IN PHARMACEUTICAL ECONOMICS

zero (Ho :SCAR T1 , T2 = 0) is:

SCAR T1 , T2 =
(Equation 9)

where = standardized cumulative average abnormal return from T1

SCAR T , T
1 2 to T2

N = number of securities in the sample

j
Q T , T = variance corrected for a multiday event window
1 2

, where (T
= 1, T2) is the test window and Dj
is the number of nonmissing trading day returns used to
estimate the parameters for security j

SAR jt = standardized abnormal return for security j during day t.

(29, 30)
Assuming abnormal returns are normal and independent across the
time period (i.e., cross-sectional independence), the multiday PSR test
statistic approaches a standard normal distribution under the null hy-
pothesis (29).
Nonparametric Tests
Generally, nonparametric tests appear in event studies to supple-
ment results based on parametric statistics. Although several nonpara-
metric tests exist, perhaps the two most commonly used in event
studies are the sign test and the rank test. Corrado and Zivney con-
ducted a simulation comparing the sign test to other statistics, while
Cowan presented a generalized sign test (37, 38). Corrado reviewed
the use of the rank test in event studies (39). The use of the Jackknife
test has also been investigated in event studies (40).

ECONOMETRIC CONSIDERATIONS
Nonnormality
The nonnormal nature of daily security returns has been docu-
mented extensively (12, 41). Evidence from simulation studies, how-
 Grant H. Skrepnek and Kenneth A. Lawson 13

ever, indicated that the residuals from an OLS estimation of SIMM

parameters more closely approximate a normal distribution, therefore
having a minimal effect on event study methodologies (12). Overall,
the use of distribution-free test statistics may not increase power and
may not appear warranted in all event studies.
Autocorrelation
The presence of autocorrelation has been documented in the residu-
als of SIMM regressions using daily security returns data (5, 41).
Autocorrelation is a violation of the assumption that the covariance of
the residuals ejt and ej,t-1 equals zero. The violation may result in
inefficient OLS estimates of model parameters, downwardly biased
variances of the coefficients, and inappropriate use of statistical proce-
dures. The Durbin-Watson procedure, which tests for the presence of
autocorrelation, is described in Johnston (42). Overall, the usefulness
of some measures to remove autocorrelation remains debatable. Under
typical conditions, corrective measures for autocorrelation are not
warranted (5).
Several methods have been developed to control for cases where
marked autocorrelation is present. For example, Mikkelson and Partch
offered a modification to the PSR statistic that corrects for autocor-
relation of residuals in event windows (43). This method has been
widely used in event studies and appears in Mais, Moore, and Rogers;
Mann and Sicherman; and Salinger (44-46). Furthermore, this correc-
tion has also been tested in simulation studies by Karafiath and Spenc-
er and Cowan (47, 48).
Brown and Warner indicated that autocorrelation may occur secon-
dary to nonsynchronous trading in the stock markets (12). Two proce-
dures to correct for a biased beta estimate from nonsynchronous data
include the Scholes-Williams beta estimate and the Dimson aggregate
coefficient estimate; Cohen et al. provided an additional method
(49-51).
Heteroscedasticity and Cross-Sectional Dependence
The presence of heteroscedasticity, or nonconstant variance, in dai-
ly returns is summarized by Henderson (5). Daily returns, in addition
to being potentially nonnormal and autocorrelated, may also be heter-
oscedastic. However, residuals of the regression equations were re-
ported to be less heteroscedastic than daily returns data (41). A correc-
14 JOURNAL OF RESEARCH IN PHARMACEUTICAL ECONOMICS

tion for the violation of heteroscedasticity includes the use of a

cross-sectional estimate of the variance and a generalized least squares
procedure. Brown and Warner illustrated that the use of cross-section-
al procedures can result in tests that are well-specified (12). However,
inappropriate use of these procedures may lead to a misspecification
of test statistics and decreased power. In cases where cross-sectional
dependence is small, corrective measures are discouraged (12).
The presence of cross-sectional dependence indicates that the
covariance of the residuals is not zero, violating an assumption of the
OLS estimation of parameters for the SIMM. Cross-sectional depen-
dence may occur when events are clustered within a short time frame,
known as calendar clustering. Calendar clustering may be present in
event studies wherein the event is concentrated within a short time
interval, especially within studies of single industries. Clustering ap-
pears to reduce power.
Bernard provided a detailed discussion regarding the problems re-
lated to clustering (52). Schipper and Thompson, Malatesta and
Thompson, and Collins and Dent discussed methods (e.g., GLS ap-
proaches) of controlling clustering in event studies (27, 36, 53, 54).
Boehmer, Musumeci, and Poulsen offered a modification of the PSR
statistic to control for increased event day variance (55). Sanders and
Robins also discussed event-induced variance and proposed methods
to control it (56).

CONCLUSION
The wide applicability of event studies has led to their extensive
adoption within business, economic, and accounting research. This
methodology has been employed to measure the wealth effects of
various events, including corporate announcements, mergers and ac-
quisitions, litigation, and regulatory changes. For pharmaceutical
economists, the event study methodology provides a valuable tool for
determining the impact of information on the capital market value of
pharmaceutical firms. Despite its usefulness, however, Henderson rec-
ognized that ‘‘[t]he sheer volume of event study literature can be
imposing to researchers that first consider the paradigm’’ (5). The
basic steps in conducting an event study remain consistent, and a
substantial amount of literature discusses each of these in detail. The
development of advanced econometric procedures continues to refine
 Grant H. Skrepnek and Kenneth A. Lawson 15

the methodology, although even the simplest event studies remain

robust in many instances. Several corrections have been developed to
control for specific statistical violations, including nonnormality, auto-
correlation, heteroscedasticity, and cross-sectional dependence.

RECEIVED: February 4, 1999

REVIEWED: August 6, 1999
REVISED: October 26, 1999
ACCEPTED: October 26, 1999

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 18 JOURNAL OF RESEARCH IN PHARMACEUTICAL ECONOMICS

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