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Investments Case 1 Event studies: How Does the Stock Price React to Important Events? FIN 411 -- Investments Examples of things you can do by analyzing stock returns Control for price behavior that is unrelated to the event market movements industry movements effects of other firm-specific events at the same time Data in Excel spreadsheets "F411M.XLS" -- monthly data from 85-94 "F411D.XLS"-- daily data from 85-94 Remember: stock price reaction measures the effect of new information similar data in Eviews files f411D.WF1 & F411M.WF1 i.e., revision of expectations Polaroid - Kodak Stock Returns, 1983-89 Polaroid & Kodak Had Protracted Litigation Over Instant Photography Patent Rights Many events over several years: PRD reorganizes: Layoffs & buyback 40% Monthly Percentage Returns two-phase trial: (1) liability, then (2) damages appeals at every major outcome security analysts were valuing both companies based on the expected outcome of the suit Supreme Court won't hear EK appeal 20% 10% 0% -10% -20% EK will appeal EK seeks to vacate rulings Jul/89 Jan/89 Jul/88 Jan/88 Jul/87 Jan/87 Jul/86 Jan/86 Jul/85 Jan/85 Jul/84 Jul/83 Jan/84 Jan/83 -30% Kodak & Sterling Drug Merger Announced January 1988 Kodak was "White Knight" Bidder for Sterling Drug Target Kodak 0% -20% -40% 1-6 Jul/90 Jan/90 Jul/89 Jan/89 Jul/88 Jul/87 Jan/88 Jul/86 Jan/87 Jan/86 -60% Jan/83 ε(it) = R(it) - α(i) - β(i) R(mt) Merger announcement 20% Jul/85 then form prediction errors for 1/87-end: Estimation Period: 1/83-12/86 40% Jul/84 I estimated the market model using monthly returns from 1/83 - 12/86 60% Jan/85 On 1/22/88 Kodak offers $89.50/share for Sterling Sterling 80% Jul/83 Cumulative Abnormal Returns (12/86 = 0) Hoffman-LaRoche bid $72/share for Sterling (STY) in early 1988 Prof. Schwert PRD seeks $5.7 bil damages EK loses round PRD wins patent suit 30% Jan/84 FIN 411 Spring 1997 Investments Case 1 GM Pursues Large Diversifying Acquisitions Performance of GM Stock (Autos, EDS & Hughes) GM $1 GMH Investment Opportunity Set (Mean vs. Std Deviation) Jul/90 Jul/89 Jan/90 Jul/88 Jan/89 Jan/88 Jul/87 Jan/87 Jul/86 Jan/86 Jul/85 $0 Jan/83 created new class of stock (GMH), linked to Hughes profits GM Acquires EDS $2 Jul/84 bought Hughes Aircraft (defense contractor) in auction GME GM Acquires Hughes $3 Jan/85 created new class of stock (GME), linked to EDS profits, and less strongly linked to the auto business the NYSE considered delisting GM for having multiple classes of stock $4 Jul/83 Value of $1 Investment Made in October 1984 bought Electronic Data Systems (EDS) Ross Perot company [recently spun-off] Jan/84 FIN 411 Avg Returns vs. Standard Deviations Rochester-related Stocks, 1984-93 Based on returns from 1984-93 4% IV STY obviously these estimates contain some estimation error Average Monthly Returns 3% usually would be surprised to see investors buy stock if they expected returns to be negative standard deviations are quite large for firms that have major surprise events PAYX 2% Rme RTC XRX Rmv 1% RCSB RGS Rsp KSM EK Rf 0% HMX IBM means are quite large for firms that are targets in takeovers (e.g., STY) -1% 0% 5% 10% 15% 20% Standard Deviations per Month Capital Asset Pricing Model: Avg Returns vs. Beta Avg Returns vs. Betas Rochester-related Stocks, 1984-93 Security Market Line: 4% IV STY E[R(i)] = R(f) + β(i) { E[(R(m) - R(f)] } Average Monthly Returns 3% I drew a line from R(f) through E[R(m)], but I also estimated a regression of average returns on beta estimates obviously these estimates contain a lot of estimation error EMF BKHT Estimated Security Market Line (regression) 2% EK Sharpe-Lintner Security Market Line (CAPM) Rm CMB 1% XRX KSM Rf 0% IBM Note the abnormal performance for the "Inefficient Market Fund" Prof. Schwert PAYX HMX -1% 0 0.5 1 1.5 2 Beta 7-12 Spring 1997