Whereas the EMH is a theory about the pricing mechanism of security maerkets,capital market research (CMR) is empirial research

wich uses statistial methods to test hypotheses concerning capital market behaviour. Most CMR uses the market model,14 wich derivers from the capital asset pricing model (CAMP),15 to estimate the unexpected (or abnormal) return on the ordinary shares of a company at the time of an event occurring (e.g. profit announcements).

Market model
Share prices and returns are affected by both market-wide and firm-specific events. Therefore,if we are attempting to research and identify the impact of firm-unique information such as the release of earned profits,the returns arising from general market-related information (e.g. state of the economy,inflation etc.) must be first controlled. For example, if a securitys return on the profit announcement day was +2.0%,this could be due to favourable market information affecting all shares,favourable firm-specific information, or a combination of both. To isolate that part of a securitys return that is unique to the firm, we use the market model: Raw return on day t = Constan average daily return + Return due to market moves i ( + Return due to firm news (12.1)

i,t

m,t

i,t

Where
i,t

= the return on the firm i in period t

= the constan average return (regasdless of return on the market) = the beta estimate of firm i (wich is a measure of sensitivity to the return on
the market)

m,t

) = the return on the on the aggregate market portofolio during period t = the residual error in period t the portion of the raw return due to firm-unique
events (individual earnings,divilend announcements or management policies). Estimates of
i and

i,t

i are determined by using ordinary least-squares regission

Which relates historical firm rates of return with historical market returns.

The regressions are normally run using 60 per-event monthly returns (t =0 to 59) over a five-year period. The market model has a number of assumptions which should be made clear :
y y

Investor are risk-averse Returns are normally distributed (the mean and standard deviation are sufficiently descriptive of security returns) and investors select their portfolios on this basis.

y y

Investors have homogeneous expectations Markets are complete (all participants are price takers,there are no transactions costs,no taxes, and there are rational expectations by investor).

According to Famas conception of efficient markets, the abnormal rate of return on firm i for the period t( set available at time t (
i,t

) is equal to the realised rate of return (Ri,t) less the ).

This is expressed mathematically as :
i,t

expected rate of return for the period t, for asset i (E(Ri,t)), given the information
t 1 16

= Ri,t (E(Ri,t :

t 1

(12.2)

Taking expectations : E(Ri,t) =

i

+ iE(Rm,t)

(12.3)

The estimated abnormal rate of return for period t is the difference between the actual return and the expected return :
i,t

i,t

- iE(Rm,t)

(12.4)

In an efficient market, such abnormal rates of return will average to zero across many period (T ):  (12.5)

The abnormal return derived from the market model

i,t captures

that part of the

total return not attributable to factor affecting the market portfolio but, rather, to firm-specific factor. It is for this reason that abnormal returns,
i,t

, are studied

of share prices to accounting factors hypothesised to affect specific companies.

These concepts can be illustrated by the folowing example. Assume you are given the folowing one-period market model data on BHP Biliton (BHP) for the calendar quarter ending june 2009:
BHP =

2.0%

RBHP = 12.0% R M = 10.0%

BHP = 0.7

These data are displayed in figure 12.1. If the market index (e.g. the Australian All Ordinaries) had a return of 0 per cent, the expected return on BHP Billiton would be 2 per cent ( ). However, the market had a 10 per cent return. The BHP of 0.7 indicates that a 10 per cent index return is expected to result in a 7 per cent return on BHP Billiton above the constant 2 per cent. Adding the 2 per cent and 7 per cent result in an expected return of 9 per cent. However, BHP Billitons actual return was 12 per cent. The difference between the actual 12 per cent and the expected 9 per cent is the error during this time period, 3 per cent, and is called the abnormal return.

Actual return = Error 12% { + Sensitivity to Market + Constant 2% } 10%

BHP t m,t BHP t

 BHP t = 3%

BHP t

BHP t

BHP t

m,t

9%
BHP t

= 0.7

= 2%

FIGURE 12.1 Sample market for i = BHP and t = quarter ending june 2009

Two additional steps are usually taken before data from capital market research are analysed. First, an averge firm-unique return (AR) is found for each month (or discrete period selected) for all firms in the study, by adding up and dividing as follows: Average market model residual in month t : ARt =


Where AR t = average firm-unique return for month t

i,t

= firm-unique return on shock i during month t

N = number of firms examined in a given month. Second , a cumulative average abnorrmal firm-unique return (CAR) is found for each month by summing all average firm-unique returns for a particular month. Mathematically, using 18 monthly observations (6 after the specified event and 12 up to the event day ) We have : Cumulative market model residual in month t : CAR t = Where 12 
6 12
t

To empirically evaluated the price impact of accounting information, either the ARt or the CARt values may be examined. If the released accounting numbers have incremental information (i.e. not previously known and acted on by the market) then there will be zero (or close). If the y are zero then either the accounti g numbers do not have information content or the market ha used other information and does not await the release of accounting reports before making pricing decisions. Having the prerequisite understanding of the market model we now turn to a consideration of the empirical studies.