Cumulative Abnormal Return (CAR): Evaluating the Impact of News on Stock Prices

Highlights:

• CAR measures the total difference between expected and actual stock returns over a period.
• It helps assess how news or events influence stock prices.
• CAR is useful in event studies to understand market reactions to specific announcements.

Introduction

Cumulative Abnormal Return (CAR) is a financial metric that evaluates the performance of a stock relative to what was expected, typically over a specific event window. It is calculated by summing the abnormal returns for each period during the window of analysis. Abnormal returns are the differences between the actual return on a stock and the expected return, which is often derived from a model that accounts for the stock’s systematic risk and overall market return.

The expected return is usually calculated by multiplying the stock's sensitivity to market movements (systematic risk, or beta) by the realized market return during the same period. Any deviation from this expected return is considered "abnormal" and is attributed to specific events, such as earnings announcements, regulatory changes, mergers, or other news items that might affect a company's stock price. By aggregating these abnormal returns over time, CAR provides a way to measure the cumulative effect of these events on the stock's value.

Understanding CAR Calculation

The CAR is calculated by first determining the expected return for each time period in the event window. The expected return is often computed using models like the Capital Asset Pricing Model (CAPM), which predicts the return based on market movements. The actual return is then compared to the expected return, and the difference is the abnormal return for that period. Abnormal returns can be either positive or negative depending on whether the actual return is greater or less than the expected return.

Once abnormal returns for each period are calculated, they are summed over the entire event window to obtain the cumulative abnormal return. This sum represents the total impact of the event on the stock price, aggregating the influence over several days or weeks, depending on the scope of the study. The event window can vary in length, ranging from a single day to several weeks, and is chosen based on the timing and expected influence of the news event.

Application of CAR in Event Studies

One of the primary uses of CAR is in event studies, where researchers or analysts seek to understand how specific news or events impact stock prices. Common events studied include earnings reports, product launches, changes in management, regulatory approvals, and significant geopolitical events. By examining the CAR during the event window, analysts can determine whether the event had a significant effect on the stock price.

For example, if a company announces a major new product, analysts may measure the CAR for several days before and after the announcement to assess whether the stock price responds positively or negatively. A positive CAR suggests that the market viewed the event favorably, while a negative CAR implies the market’s unfavorable reaction.

CAR is particularly useful for evaluating the market's reaction to unexpected news. Since abnormal returns are considered to be driven by information not already reflected in the stock price, CAR can help gauge how efficiently the market processes new information. It also serves as a tool to test hypotheses about market behavior, such as whether investors react to certain types of news in a predictable manner.

Limitations of CAR

While CAR is a powerful tool, it has some limitations that researchers and analysts must keep in mind. One limitation is that it assumes all abnormal returns are caused by the event being studied, but this may not always be the case. Other factors, such as broader market movements or external economic conditions, can also influence stock returns during the event window, potentially confounding the results.

Another challenge is the difficulty in accurately modeling expected returns. The choice of model and the time period used to estimate the expected return can have a significant impact on the CAR calculation. For instance, using too short a time window to estimate expected returns might not capture longer-term trends in the market, while using too long a window might dilute the effect of the event.

Furthermore, CAR assumes that the market is efficient and that stock prices fully reflect all publicly available information at all times. However, in reality, markets can be influenced by a variety of factors, such as investor sentiment, speculation, or information asymmetry, which can lead to deviations from expected returns.

Conclusion

Cumulative Abnormal Return (CAR) is a vital metric in finance, offering valuable insights into the market’s response to specific events or news. By calculating the sum of abnormal returns over a defined period, CAR helps investors and analysts assess the impact of announcements, earnings reports, or other significant events on stock prices. Although CAR has its limitations—such as the influence of external factors and the assumptions about market efficiency—it remains a widely used and essential tool in event studies. By providing a clear view of how stocks react to news, CAR enables better decision-making for both investors and corporate stakeholders.