On the use of the Log CAR measure in Event Studies

Gishan Dissanaike*
University of Cambridge

Alexandre Le Fur
Dresdner Kleinwort Benson

This is a revised version of a University of Cambridge Research Paper in Management Studies, 2000, WP 08.

ABSTRACT Cross-sectional averages of log returns have been used to measure shareholder wealth effects in several event studies. No adequate explanation of the implied portfolio strategy has ever been provided in the literature. We argue that the method is biased or does not portray a realistic portfolio strategy. It should therefore be used with caution in the 'event-study' literature. JEL Class: G14, G34 Keywords: Event studies, Logarithmic returns, Cumulative Average Returns, Geometric means

*Dissanaike is a tenured faculty member of the Judge Institute of Management, Trumpington Street, Cambridge CB2 1AG, UK. Tel: +44 (0)1223-339700. Fax: +44 (0)1223-339701. e-mail: grd13@cam.ac.uk. The authors are grateful to Bart Lambrecht and Shiyun Wang for comments. Dissanaike acknowledges support from the Economic and Social Research Council (Grant No. H53627503496) and the Institute of Chartered Accountants of England & Wales. Le Fur acknowledges support from the British Council and Kleinwort Benson Bank.

On the use of the Log CAR measure in Event Studies

ABSTRACT Cross-sectional averages of log returns have been used to measure shareholder wealth effects in several event studies. No adequate explanation of the implied portfolio strategy has ever been provided in the literature. We argue that the method is biased or does not portray a realistic portfolio strategy. It should therefore be used with caution in the 'event-study' literature.

JEL Class: G14, G34

I. INTRODUCTION Cross-sectional averages of logarithmic returns (LCAR) have been used in several event studies to assess shareholder wealth effects around certain events. It has been used to study defense procurement fraud (Karpoff et al., 1999), public offerings of state-owned and privately-owned enterprises (Dewenter and Malatesta, 1997), mark-up pricing in mergers and acquisitions (Schwert, 1996), takeovers (Franks and Mayer, 1996; Eckbo and Thorburn, 2000), investment banks and acquisitions (Servaes and Zenner, 1996), overreaction (Ahmad and Hussein, 2001)1, equity issuance and adverse selection (Houston and Ryngaert, 1997), proxy contests (Mulherin and Poulsen, 1998), rights offerings (Bohren et al., 1997), market microstructure (Amihud et al., 1997), management buyouts (Lee, 1992), and interest rate swaps (Harper and Wingender, 2000).

The LCAR is just one of the methods that have been used to measure wealth effects. Others include the Buyand-Hold (BH), Re-balancing (RB), and Cumulative Average Return (CAR) methods. If the objective is to measure the return that can be earned by investing in the sample firms over a particular horizon, the chosen method should simulate a realistic portfolio strategy, or else wealth effects will not be measured accurately (see Barber and Lyon, 1997, and Lyon et al., 1999). Although the interpretations of the BH, RB, and CAR have been discussed extensively,2 we have not found a satisfactory discussion on whether the LCAR embodies a realistic strategy.

1
2

However, they also presented results using buy-and-hold returns.

Barber and Lyon, 1997, Dissanaike, 1994, Kothari and Warner, 1997.

The basic LCAR can be represented as:

RLCAR =
t =1 i =1 T N

ln[Rit ] , N

(1)

where Rit is one plus the return on security i [t-1,t] and N is the number of stocks in the portfolio. Some researchers used a variant of (1) to take account of risk.

The LCAR was first used by Fama et al. (1969) who argued that, "the Logarithmic form of the model appears to be well specified from a statistical point of view and has a natural economic interpretation (i.e., in terms of monthly rates of return with continuous compounding). While Kothari and Warner (1997), and Barber and Lyon (1997) have shown that log returns are negatively skewed, such that test-statistics are unlikely to be well specified, our chief concern is with whether the LCAR has a meaningful interpretation. We argue that, even though the log return of a single security has a natural economic interpretation, this is no longer the case when securities are aggregated into portfolios and log returns are averaged.

We prove that the LCAR is equivalent to the Log Geometric mean. This simple (new) result allows us to make a link with research on the Geometric mean and its implied portfolio strategy, a topic discussed in the seventies and early eighties. Surprisingly, this link has not been made before.

2.

PROOF THAT THE LCAR IS EQUIVALENT TO THE LOG OF THE GEOMETRIC MEAN

Without loss of generality, we assume that stocks do not pay any dividends. If one were dealing with a single
T Pi , t Pi , T (2) security, the LCAR would be: RLCAR = ln Pi , t 1 = ln Pi ,0 , t =1

which is simply the continuously compounded return on a realistic, BH strategy: Exp( RLCAR ) = Pi , T .
Pi , 0

Unfortunately, this reasoning does not carry over to a portfolio of N securities, where N>1. Thus, if
Pi , t ln Pi , t 1 , RLCAR = N t =1 i =1
T N

(3)

Pi , T Pi ,0 . Exp( RLCAR ) N i =1
N

Instead, the LCAR implies multiplying returns over time and across securities:
1 T N Pi , t N RLCAR = ln , t =1 i =1 Pi, t 1

(4)

or equivalently:
1 N Pi , T N RLCAR = ln i = 1 Pi , 0

(5)

RLCAR = ln[G[ 0, T ]].

Thus, the LCAR is equivalent to the Log of the Geometric mean. This result is admittedly simple, but it indirectly allows us to draw on the earlier geometric mean literature to provide an interpretation for LCAR.

3. THE INTERPRETATION OF THE GEOMETRIC MEAN

3.1 CASE I: Security price functions are continuous and differentiable

Rothstein (1972) and Hodges and Schaefer (1974) proved that if price functions are positive, continuous and differentiable, the Geometric mean measures the performance of a portfolio that is continuously rebalanced to equal weights. Thus, by implication, LCAR measures the instantaneous return on a continuous re-balancing strategy. However, as Rothstein pointed out, continuous re-balancing cannot be literally implemented by a portfolio manager and it involves high transaction costs.

3.2 CASE II: Security price functions are continuous but not differentiable
Brennan and Schwartz (1985) showed that the Geometric mean appreciates at the same rate as the value of a continuously re-balanced portfolio if, and only if, there is no uncertainty about the rate of increase in security prices (i.e. price functions are differentiable). They investigated the more realistic case where price functions were not differentiable, and showed that the Geometric mean actually underestimates the value of a continuously rebalanced portfolio, the bias depending only on the covariance matrix of the instantaneous returns. This bias would vary across countries, portfolios and securities.3

4. CONCLUSIONS If security price functions are continuous and differentiable, the LCAR measures the instantaneous return on a strategy involving continuous re-balancing. This is unrealistic because continuous re-balancing cannot be implemented literally and it involves high transaction costs. Even if transaction costs were zero, it is questionable whether the LCAR is appropriate for an event-study. Given that the researcher is trying to measure wealth effects around some event, introducing the additional effect of continuously rebalancing could contaminate the results. Second, in the more realistic situation where price functions are stochastic, the LCAR yields a biased return on a continuously rebalanced portfolio. Finally, Kothari and Warner (1997) and Barber and Lyon (1997) show that log returns are negatively skewed, such that test-statistics are unlikely to be well specified.

Thus, if the objective of the researcher is to measure the return earned over a particular horizon, the BH (and possibly the RB) would be more appropriate than the LCAR. Instead, if the aim is to see if sample firms persistently earn excess returns, the CAR would be more suitable than the LCAR, 4 as the former is based on a series of successive buy-and-hold returns, whereas the latter is based on a series of log geometric means.5 The LCAR should therefore be used with care in event-studies. 6

Since continuous rebalancing may not anyway be appropriate in an event-study context, we do not estimate the bias. But Brennan and Schwartz estimated that it could be around 4.3% per annum, for large N. 4 CARs are considered appropriate if the objective is to test whether sample firms persistently earn abnormal returns, but not appropriate to measure the return earned when one invests in a sample of firms over a particular horizon (see Barber and Lyon, 1997). 5 Each monthly geometric mean would therefore yield an unrealistic return. 6 The different return methods can yield vastly different results: Kothari and Warner (1997) who used 50,000 long-horizon (3-year) returns found that the BH, CAR and LCAR yielded mean market-adjusted returns of 5.3, 3.9 and 15 percent, respectively!

References Ahmed, Z. and Hussain, S., 2001, KLSE long run overreaction and the Chinese New Year effect, Journal of Business Finance & Accounting, Vol. 28, No. 1/2, pp. 63-105. Amihud, Y., Mendelson, H., and Lauterbach, B., 1997, Market microstructure and securities values, Journal of Financial Economics, 45, pp. 365-390. Barber, B.M., and Lyon, J.D., 1997, Detecting long-run abnormal returns: the empirical power and specification of test statistics, Journal of Financial Economics 43, pp. 341-372. Bohren, O., Eckbo, B.E., and Michalsen, D., 1997, Why underwrite rights offerings?, Journal of Financial Economics, 46, pp. 223-261. Brennan, M., and Schwartz, E., 1985, On the geometric mean index, Journal of Financial and Quantitative Analysis, March, pp. 119-122. Dewenter, K., and Malatesta, P., 1997, Public offerings of state-owned and privately-owned enterprises, Journal of Finance 52, pp. 1659-1679. Dissanaike, G., 1994, On the computation of returns in tests of the stock market overreaction hypothesis, Journal of Banking and Finance 18, pp. 1083-1094. Eckbo, B. and Thorburn, K., 2000, Gains to bidder firms revisited, Journal of Financial & Quantitative Analysis, 35, pp. 1-25. Fama, E., Fisher, L., Jensen, M., and Roll, R., 1969, The adjustment of stock prices to new information, International Economic Review 10, pp. 1-21. Franks, J., and Mayer, C., 1996, Hostile takeovers and the correction of management failure, Journal of Financial Economics 40, pp. 163-181. Harper, J.T. and Wingender, J.R. (2000), An empirical test of agency cost reduction using interest rate swaps, Journal of Banking & Finance 24, pp. 1419-1431. Hodges, S., and Schaefer, S., 1974, The interpretation of the geometric mean. Journal of Financial and Quantitative Analysis, June, pp. 497-504. Houston, J., and Ryngaert, M., 1997, Equity issuance and adverse selection, Journal of Finance 52, pp. 197-219. Karpoff, J., Lee, D., and Vendrzyk, 1999, Defense procurement fraud, penalties and contractor influence, Journal of Political Economy, 107, pp. 809-842. Kothari, S.P., and Warner, J., 1997, Measuring long-horizon security price performance, Journal of Financial Economics 43, pp. 301-339. Lee, D., 1992, Management buyout proposals and inside information, Journal of Finance, 47, pp. 1061-1079. Lyon, J., Barber, B.M., and Tsai, C., 1999, Improved methods for tests of long-horizon abnormal stock returns, Journal of Finance, 54, pp. 165-201.

Mulherin, J. H., and Poulsen, A., 1998, Proxy contests and corporate change, Journal of Financial Economics, 47, pp. 279-313. Rothstein, M., 1972, On geometric and arithmetic portfolio performance indexes, Journal of Financial and Quantitative Analysis, September, pp. 1983-1991. Schwert, G.W., 1996, Mark-up pricing in mergers and acquisitions, Journal of Financial and Quantitative Analysis, 41, pp. 153-192. Servaes, H. and Zenner, M., 1996, The role of investment banks in acquisitions, Review of Financial Studies 9, pp. 787-815.

NOTES TO REFEREES
1. The LCAR has been used in many other event-studies published after 1990, including studies on toehold acquisitions, changes in the composition of the Dow Jones Industrial Average, outside directorships, anti-trust policy, etc. We do not refer to all these areas in the text, due to space constraints.

2. Note that the Geometric mean is insensitive to the number of sub-intervals in a given time period
[0,T]. Therefore, the final portfolio return is insensitive to the use of daily, weekly, or monthly data i.e., only the starting and final prices are taken into account in the computations (see Rothstein, 1972):
1 N

G [ 0, T ] =
i =1

P P
i, T i,0

G[ 0, T ] =
i =1 t =1 T

P P
i, t i, t 1

1 N

G[ 0, T ] = Gt.
t =0