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All Events Induce Variance: Analyzing Abnormal Returns When Effects Vary across Firms

Published online by Cambridge University Press:  06 April 2009

Scott E. Harrington  and
David G. Shrider
Scott E. Harrington
Affiliation:
harring@wharton.upenn.edu, University of Pennsylvania, Wharton School, 3541 LocustWalk, Philadelphia, PA 19104
David G. Shrider
Affiliation:
shridedg@muohio.edu, Miami University, Richard T. Farmer School of Business, 501 E
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Abstract

We demonstrate analytically that cross-sectional variation in the effects of events, i.e., in true abnormal returns, necessarily produces event-induced variance increases, biasing popular tests for mean abnormal returns in short-horizon event studies. We show that unexplained cross-sectional variation in true abnormal returns plausibly produces nonproportional heteroskedasticity in cross-sectional regressions, biasing coefficient standard errors for both ordinary and weighted least squares. Simulations highlight the resulting biases, the necessity of using tests robust to cross-sectional variation, and the power of robust tests, including regression-based tests for nonzero mean abnormal returns, which may increase power by conditioning on relevant explanatory variables.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 42 , Issue 1 , March 2007 , pp. 229 - 256
Copyright
Copyright © School of Business Administration, University of Washington 2007

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