Table of Contents

1. Introduction 1.1. 1.2. 1.3. 2. Introduction The Hypothesis The Nature of the Information Events 2 2 2 3 5 5 6 15 19 19 21 23 25 25 25 28 30 32 34 35 35 36 37 38 39 40 42 43 44 45

Literature Review 2.1. 2.2. Event Study Measuring Abnormal Returns

3. 4.

Regression Methodology Results 4.1. 4.2. 4.3. The Description of the Data The Regression Residual Analysis

5.

Testing the Linear Regression Assumptions 5.1. 5.2. 5.3. Linear Regression Assumptions Homoscedasticity Serial Correlation

6. 7. 8. 9.

Testing Coefficient Stability Limitations and Conclusion Bibliography Appendix 9.1. The Discussion of the Events 9.2. Alternative Benchmarks for Measuring Abnormal Returns 9.3. Estimation of Equity Beta for the CAPM Model 9.4. The Three-Factor Model 9.5. Goodness of Fit: The F-Test 9.6. Non-parametric Significance Tests 9.7. Calculation of Prediction and Confidence intervals 9.8. Extreme Outliers 9.9. Remedies for Heteroscedasticity 9.10. Binomial Distributions Methodology

1. Introduction
1.1 Introduction
This assignment carries out an event study on BT Group PLC, the UKs leading Telecommunications Company, in order to examine the stock market reaction and the stochastic behaviour of BTs share prices following the disclosure of four independent firm-specific events, which occurred in a span of eight months (28th of September 2011 1st of June 2012). A thorough analysis will attempt to determine the significance of each event and the possible impacts they may have had on BTs share prices.

1.2 The Hypothesis

An event is considered to be significant, if its disclosure caused BTs shares to generate abnormal returns. Using this information a hypothesis can be formed. A hypothesis is the means of testing the validity of a claim, which in this case is the generation of abnormal returns following the disclosure of an event. The most popular method of mathematically demonstrating this hypothesis has been adopted from Gonedes (1975) and is shown by formula (1). ( | ) ( | )

The Null hypothesis states that abnormal returns on BTs share prices, conditional on the firm-specific event on BTs share prices. equals zero. In other words event had no significant impact

1.3 The Nature of the Information Events

Four events will be examined in this assignment. These events have been summarized in the caption of the graphs shown below and are later discussed in detail. The graphs which had been captured from Yahoo Finance are simply the snapshot of the movement of BTs share prices at 5 working days prior and after the occurrence of each event.

28/09/2011- Announcement of possible purchase of BTs stake in Tech Mahindra by Mahindra and Mahindra ltd

11/01/2012 - Staples signing a four year contract with BT

07/03/2012 - BT signing a five year outsourcing deal with Standard Life

01/06/2012 - BT Group PLCs BT Global services selling the French Application Development business to Osiatis

BT Group PLC, which is trading under BT. A in London Stock Exchange (LSE) is UKs leading telecommunications services company, which provides services to government and corporate organizations, and also operates a retail business providing households with broadband, TV subscriptions and telephones. The events chosen include major contracts, agreements, and the BTs sale of its stake in a company. Due to the nature of BTs business, the disclosure of these announcements is expected to have had major impacts on its share prices. Signing contracts and agreements with big clients for instance would have translated into the improvement of BTs reputation and prospects, which in turn would have meant more analysts were to give positive recommendations on BTs stocks. These events are discussed in more detail in the Appendix.

2. Literature Review
2.1 Event Study
An event study is the name given to an empirical investigation of the relationship between security prices and economic events (Strong, 1992). An event study which is also referred to as residual analysis focuses on the effects, if any, of the disclosure of firm specific events on the security prices. There are many models for measuring the impact of these events on the stock market. The impacts of many such events (e.g. Agreements, mergers, etc.) have previously been studied and analysed. Brown and Warner (1980, 1984) highlighted the use of event study as means to test the market efficiency. They further discussed the inconsistency of the systematic nonzero abnormal returns persisting after an event, with the hypothesis of the immediate adjustment of security prices following its disclosure. They used the simulation technique to analyse the capability of these models in measuring abnormal returns. This assignment attempts to examine the extent to which the numerous studies and their associated models have been helpful in measuring the stock market reaction to these events. Conducting event study is often initiated by forming a hypothesis as shown in the previous section. If an event contains what is referred to as information content, then the Null hypothesis is often rejected1 as the information signal results in the security generating abnormal returns. According to Strong, the basic structure of an event study (residual analysis) contains 3 steps. These steps are as follows:

This of course depends on the level of significance specified when using the t-statistic.

1. In the first step event dates are identified for a sample of firms2 and the observations are grouped into a common event time. 2. The abnormal return for each firm is calculated for each period around the announcement date, within the overall test period. ( )

3. The cross-sectional mean abnormal returns are calculated in the sample, cumulated over the test period in order to derive an estimate of the hypothesis can be tested. It is important to highlight that this methodology assumes that the study is using crosssectional data, which implies that the impact of one event has been analysed across different firms. However in this assignment it is required to conduct an event study using time series analysis, which simply means that the impact of a few events over time are analysed only on one firm. ). Using a test statistic then

2.2 Measuring Abnormal Returns

Various methods have been utilized in numerous studies for the measurement of abnormal returns. In this section some of these methods will be discussed and their advantages and disadvantages will be analysed. The literature has highlighted the importance of several factors which are needed to be considered for calculating abnormal returns.

In the study conducted by Strong, cross-sectional analysis is used. In other words, the effect of one event on a sample of firms is analysed at one point in time. In this assignment however, the impact of the event is analysed only on BTs share prices over a period of time.

Computing the Returns The calculation of the returns can be done using either the discrete or logarithmic methods. The mathematical formulae for calculating the discrete and lognormal returns are shown below.

Where:

There are numerous reasons as to why logarithmic returns are preferred to the use of discrete returns. Norman highlighted in his paper, the existence of both theoretical and empirical reasons for the preference of logarithmic returns. In theory logarithmic returns capture the compounding effect of the rate of return and are analytically more tractable when linking together sub period returns to form returns over longer intervals (Strong, 1992). Empirically, discrete returns tend to be positively skewed, whereas logarithmic returns are more likely to be normally distributed. This makes sense as the returns have a lower limit3, whereas there is no upper limit as to how much an investor can gain. A normal distribution is desired as it conforms to the parametric statistical techniques used in event studies.

An investor cannot lose more than 100% of his investment.

Due to the benefits of logarithmic returns, it will be used for conducting the event study in this assignment. For incorporating this method the adjusted closing prices are used. Adjusted closing prices take into account corporate actions such as stock splits, dividends, and right offerings. Hence the calculation of the returns is simply done by using formula (3).

Measurement Interval In numerous studies many different measurement intervals had been used for calculating the returns. In 1984, Brown and Warner, using some of the return generating models, conducted an event study using daily stock returns in order to test these models ability in identifying abnormal returns. Morse (1984) approached this matter analytically and examined the econometric trade-off between the decision of choosing monthly and daily data. Fama (1976) showed that the degree of non-normality of daily stock returns extends that of the monthly returns, however Brown and Warners analysis in 1984 indicated that the non-normality of daily returns, did not have a big impact on the power of the test of the various methods they used for conducting the event study. Morse further discussed that unless there is doubt in the precision of the date of the information event, a shorter interval is preferred for detecting the effects of the announcement on the share prices as it increases the efficiency of the study and reduces its bias.

This assignment requires the use of daily stock data, which appears to conform to the suggestion of some notable authors. Although daily stock data tend to be non-normal, they seem better at capturing the effects of the events on the stock market. However statistically speaking a big enough sample size results in the convergent of the distribution to normality. That is not to say that there are no limitations to using such a short interval. An example is the limitation of the daily stock data when the Market Model is used4.

The Benchmark for Abnormal Returns Returns are said to be abnormal, only when compared to a specific benchmark. Hence it is initially important to define a model which generates normal returns and once such a model is specified then abnormal returns can be measured accordingly. Brown and Warner (1980) concentrated on three models of Mean-Adjusted Returns, Market-Adjusted Returns and Market and Risk Adjusted Returns, for computing the exante expected returns. Strong has further discussed the use of Market Model, and the Matched Control Portfolio Benchmark. Since the use of Market Model is required for conducting this study, it will be explained in more detail.

The Market Model This model, which is the most popular benchmark in conducting event study, makes no explicit assumptions as to how the equilibrium security prices are determined
4

Brown and Warner found, that the use of Market Model for random stock data at short intervals is not better in capturing the abnormal returns than models which do not take into account market-wide factors and company-specific risks.

(Strong, 1992). According to the Market Model the returns are calculated by the following formula: This formula simply states that the return on security j is a systematic linear function of the market return and unsystematic linear function of . The error term is

uncorrelated with the market return and has a mean of zero with a constant variance. This Model is equivalent to formula (3) where both and are estimated by using the OLS regression over the estimation period. An underlying reason for the preference of the Market Model lies behind the fact that this model results in smaller variances of abnormal returns (Strong, 2012). The findings of Dyckman et al further agree with that of Brown and Warner and even conclude that the non-normality of the abnormal daily returns has no significant effect on the event-study. This translates into stronger statistical tests, and it results in less correlation between the error terms which conforms to the regression assumptions. The Estimation and the Testing Period In order to measure the abnormal returns for a security using the Market Model, the history of the returns of that security is divided into an estimation period (EP) and a testing period (TP). The point of having an estimation period is to measure the parameters of the expected benchmark return using regression analysis. Once the parameters of the expected benchmark return are known, the abnormal return can then be calculated within the test period. It has been suggested that the estimation period could be on either side of the test period. In practice it is often chosen close to the test period, without overlapping it. An overlap would result in a bias as the measurement of
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the parameters of the expected benchmark returns are influenced by the events under investigation.

EP

TP

t= - T

t= - s

t=0 Event date

According to Strong numerous different numbers of observations had been used in the literature for estimating the parameters of the Market Model. For instance, the number of daily observations used by Lambert and Lacker (1985), differed significantly from those used by Dodd et al. (1984) with a difference of 60 to 600 observations. Strong also suggested that in practice there appears to be a trade-off between incorporating more data into the model for the sake of statistical accuracy and not using data which are too far ahead or back from the test period5. In practice however, one important issue to consider is the availability of data. Some studies have shown that the exclusion of the testing period in estimating the benchmark parameters could result in a bias when there is a correlation between the events and parameters. If this is not the case, then the exclusion of the testing period is appropriate.

This could result in using data from periods where the mechanisms under which the returns are generated have changed and hence there will be a shift in the parameters.

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In this assignment a total of 250 daily observations will be used as shown in the diagram below.

EP

TP

t= -244

t= -5

t= 0

t= +5

As discussed before various different numbers of observations had been used in the past and although higher number of observations is preferred for the sake of statistical accuracy, the dynamics of return generating models may have had changed over long periods of time. Hence by choosing a period of one year6 it is unlikely that these mechanisms had changed much and the analysis will be of more accuracy. Furthermore Brown and Warners even-study experiment on daily data in 1984 was the source of inspiration for the choice of number of observations in this study. Choice of the Market Index The calculation of the abnormal returns using some of the benchmark models previously discussed requires the use of indices as they represent the market return of these models. There are various indices with different number of constituent securities, different ways in which the mean of the index security prices are calculated, and different weighting schemes such as the value-weighted, equal-weighted, and the market capitalisation. Naturally the index which results in the most accurate results is sought after. Brown and Warner (1984) using monthly data concluded that the use of

Since the market is closed on the weekends, a year translates into roughly 250 days.

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equal-weighted indices results in more powerful tests than the value-weighted index. However in the models which incorporate the CAPM, a value-weighted index including all the capital assets gives the most accurate results. As suggested by Roll (1977) the ability to measure such data is important. Realistically the availability of data is a vital factor and previous analysis had been done using various different weighted indices7. This assignment will use the domestic index of FTSE ALL-Share Index, which represents 98-99% of UK market capitalisation. There are two underlying reasons for choosing this index. Firstly, higher number of capital assets will be a better representative of the market return, and secondly, investors have a tendency to invest in their own domestic stock market, due to the expectation of getting greater legal protection. Also they are feared by the information asymmetry lying within foreign stock markets (Brealey, 2006). The issue with this index is that, even though the weighting of the constituent securities have been taken into consideration, arithmetic averaging will result in higher priced securities to have a bigger impact on the average return than the lower priced ones. Testing the Significance Most event study methodologies require the accumulation of the abnormal returns over the testing period. The main underlying reason for this is to capture the effect of an event in full as there may be information leak prior to the disclosure of the event and a momentum effect post event due to the investors overreaction. Another main reason for accumulating the abnormal returns could be due to uncertainty regarding the exact date of the event. This methodology is often used for cross-sectional data by averaging

An example would be the use of FTSE-All Share index, which is a market capitalisation weighted index, by Dimson and Marsh (1986).

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abnormal returns across firms and then cumulating the mean abnormal return over the testing period. The method used in this assignment is the average abnormal return denoted AR. The steps are as follows:

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3. Regression Methodology
Regression analysis is the means of calculating the relationship between an independent and dependent variable. The Market Model requires and parameters to be estimated in order to calculate the abnormal returns. For this assignment a relationship is to be established to determine the impact of FTSE-All share index on BTs share prices. The population regression would be as shown in the below formula.

In reality there is dispersion of RBT values around each conditional expected value which results in a noise or in this case abnormal return. The error term allows us to express the population regression as shown in the Market Model in the form:

The error term indicates the effects of RFTSE on RBT not included in the model. In order to obtain the parameters for the Market Model, the OLS regression is used. There are few reasons for choosing this method. The calculation of sample parameters and their interpretation and analysis is understood across multiple fields of studies; hence statistical software packages make it easier for users to apply OLS regression.

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Furthermore there are theoretical benefits in using the OLS. The coefficients estimated by the OLS are said to be efficient, consistent and unbiased. The process of Ordinary Least Squares estimation attempts to estimate the population parameter j with corresponding values for bj that minimizes the squared residuals (i.e. error term). Given that the sample linear regression is:

The OLS sample coefficients are those, which minimize:

The slope coefficient b1, which describes change in Rj for one unit of change in Rm is calculated as below:

The coefficient b0 is the intercept of the line with the Rj axis when Rm=0, and is calculated:

The OLS regression requires a number of assumptions which will be discussed in detail in section 5.1.

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Coefficient of Determination The coefficient of determination which is denoted R2 measures the goodness-of-fit of the regression. This measure is the percentage variation in the dependent variable explained by the independent variable. The underlying concept is that around each sample mean there is a total sum of squares (TSS). The regression equation which is independent of the error terms explains a portion of the TSS. Hence the rest is explained by the Sum of squared errors (SSE), which has already been calculated as shown in formula (13) by summing and squaring the residuals resulted by substituting a given slope and intercept coefficient in the formula. Hence it can be said that: Where:

This relationship can thus be written as:

The coefficient of the determination for the case where there is only one independent variable can be calculated as follows8:

In the case of a multiple regression, the adjusted R should be used as the ordinary R systematically increases with each added independent variable.

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This assignment by regressing RBT against RFTSE is attempting to determine the level of influence that a change in RFTSE has on RBT. If a change in the RFTSE causes a significant change in RBT, it can be said that this change is mainly explained RFTSE as opposed to the error term. The coefficient of determination is a good measure in determining this explanatory power.

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4. Results
4.1 The Description of the Data
The Estimation Period As described earlier, the number of days used for the estimation period is 239 days. The returns for BT and the market (FTSE) for this period had been calculated using the logarithmic method.
Summary for BT Lognormal Returns
A nderson-D arling N ormality T est A -S quared P -V alue < M ean S tD ev V ariance S kew ness K urtosis N M inimum 1st Q uartile M edian 3rd Q uartile M aximum -0.16045 -0.18479 9 5 % C onfide nce I nte r v als
Mean Median -0.2 -0.1 0.0 0.1 0.2 0.3

1.58 0.005 0.06418 1.76277 3.10734 -0.09856 2.33209 239 -7.47812 -0.88252 0.00000 1.12303 5.90938 0.28880 0.25033 1.93673

-6

-4

-2

95% C onfidence I nterv al for M ean 95% C onfidence I nterv al for M edian 95% C onfidence I nterv al for S tD ev 1.61763

Graph 4.1 BTs Logarithmic Returns

Summary for FTSE Lognormal Returns

A nderson-D arling N ormality T est A -S quared P -V alue < M ean S tD ev V ariance S kew ness K urtosis N M inimum 1st Q uartile M edian 3rd Q uartile M aximum -0.17076 -0.05522 9 5 % C onfidence Inter v als
Mean Median -0.15 -0.10 -0.05 0.00 0.05 0.10 0.15

1.88 0.005 -0.02660 1.13127 1.27976 -0.50747 1.69217 239 -4.58742 -0.55290 0.00000 0.63263 2.95706 0.11755 0.14342 1.24291

-4.5

-3.0

-1.5

0.0

1.5

3.0

95% C onfidence Interv al for M ean 95% C onfidence Interv al for M edian 95% C onfidence Interv al for S tD ev 1.03812

Graph 4.2 FTSE Logarithmic Returns 19

As it was earlier suggested, in theory, the use of logarithmic returns is more likely to create a normal distribution. However as it can be seen from the results on the graphs 3.1 and 3.2, there is excess kurtosis of 2.33 and 1.69, and negative skewness of -0.098 and -0.51 on the distribution of BTs and FTSEs logarithmic returns respectively, suggesting that the distributions are negatively skewed and leptokurtic. A leptokurtic distribution is more peaked than a normal distribution, has more returns clustered around its mean, and has fatter tails meaning there are more returns with large deviations from the mean. However as suggested by Brown and Warner the nonnormality of the test does not have any significant impact on the power of the test. The Testing Period The testing period in this study includes the 5 working days period before and after the actual event date. The tables below show some of the basic statistics of the testing period for the four events both for FTSE and BTs returns:

Table 4.1 BTs TP Returns Statistics

Table 4.2 FTSEs TP Returns Statistics

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4.2 The Regression

As it was previously mentioned the Market Model is incorporated for calculating the abnormal returns. The market model is in the form of: By using the OLS regression, and regressing RBT against RFTSE in the estimation period, the parameters and are forecasted as shown in the snapshot below:

Snapshot 4.1 Regression Analysis

Now that the parameters have been forecasted, the sample regression can be written as: From the results obtained, the significance of the slope coefficient can be determined at 5% level. In order to test the significance, a hypothesis is formed:

Although the t-statistic has already been shown in snapshot 4.1, its calculation will still be demonstrated. The t-statistic is calculated using the formula:
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The degree of freedom is 237 (df=n-2). Looking at the students t-table for two-tailed test, we can clearly see that the Null hypothesis gets rejected at the 5% level of significance.

Snapshot 4.2 Students t-table

Distribution Plot
T, df=237 0.4

0.3

Density

0.2

0.1 0.025 0.0 -1.970 0 X 1.970 0.025

Graph 4.3 t-distribution

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There is strong evidence to suggest that the RBT is affected by RFTSE. The graph below shows the scatter plot of RBT against RFTSE and the estimated regression line forecasted by the OLS method.

BT Returns = 0.09271 + 1.072 FTSE Returns 5.0 2.5

Regression 95% C I 95% PI S R-Sq R-Sq(adj) 1.28149 47.4% 47.2%

Fitted Line Plot

BT Returns

0.0 -2.5 -5.0 -7.5 -5 -4 -3 -2 -1 0 FTSE Returns 1 2 3

Graph 4.4 Fitted Line Plot

From looking at the scatter plot, it is evident that there is a linear relationship between RBT and RFTSE, however understanding the explanatory power of the regression requires the use of the coefficient of determination. The results obtained on Snapshot 4.1 shows that the R2 is 0.474, which means that 47.4% of the variation in RBT is explained by RFTSE. Furthermore the green and the red lines are the 95% prediction and confidence interval respectively. A confidence interval is the interval at which for a given value of RFTSE, certain value of RBT is expected, while a prediction interval is the interval at which for a given value of RFTSE, certain value of RBT is observed.

4.3 Residual Analysis

Using the sample regression calculated in the previous section, the population regression can be written as:

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The error term (abnormal return) for the testing period is thus calculated by:

The average abnormal return, sample standard deviation, standard error for the testing period, and the t-statistic of the four events had been calculated using Excel and the results are shown in the table below. The hypothesis in section 1.2 is two-tailed and at 5% level of significance. By looking at snapshot 4.2 it can be seen that the critical value at 9 degrees of freedom and 5% level of significance is 2.262.

Table 4.3 T-statistics and Decisions

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5. Testing the Linear Regression Assumptions

5.1 Linear Regression Assumptions
There are many assumptions of the OLS regression which need to be present in order for it to be efficient, unbiased and consistent in determining the coefficients. Furthermore if these assumptions are not present the hypothesis testing done on the coefficients are no longer valid. Some of these assumptions are as follows: The expected value of error term, conditional on the independent variable is zero. (E(|Rm)=0) The Rm and Rj observations are independent and identically distributed (i.i.d). It is not likely for large outliers to be observed in the results. Large outliers may cause misleading regression results. There is no correlation between the independent variable and the error terms. The regression is homoscedastic9. No serial correlation exists for the error terms10. The error terms are normally distributed.

5.2 Homoscedasticity
The least squares regression analysis is a very powerful method with the condition that the regression assumptions are met. One of the assumptions is that the variance of the residuals across all observations in the sample is uniform. If this is not the case the regression exhibits heteroscedasticity and is no longer efficient in determining the
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The variance of the error term is constant for all values the independent variable. Knowing the value of error term for one observation, does not reveal information regarding the value of another observations error term.
10

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coefficients and the hypothesis test carried out for the slope coefficient is no longer valid. There are two types of heteroscedasticity. In the unconditional heteroscedasticity the degree of heteroscedasticity is not related to the independent variable, whereas in the conditional heteroscedasticity it is. One way of detecting heteroscedasticity is by plotting the error terms against the independent variable in order to visually determine whether there are any patterns.

Scatterplot of Error Terms vs FTSE Returns

7.5

5.0

Error Terms

2.5

0.0

-2.5

-5.0 -5 -4 -3 -2 -1 0 FTSE Returns 1 2 3

Graph 5.1 Scatterplot of Error terms vs. FTSE Returns

This figure does not indicate any apparent systematic relationship between the error terms and the independent variable, hence there appears to be no evidence suggesting the variance is not a constant. A more formal way of conducting this is by creating a hypothesis at 5% level of significance:

A regression is performed where the dependent variable is the square of the residuals and the independent variable is the estimated value of BTs returns.
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Snapshot 5.1 Regression Results

Hence the regression and the coefficient of determination are as follows:

The test statistic for this test is nR2, where n is the number of observations.

By referring to a Chi-Square table, at 5% level of significance and 1 degree of freedom, the critical value is found to be 3.841. Therefore the Null hypothesis cannot be rejected. This verifies the previous graphical findings. It is thus safe to say that the regression is Homoscedastic and the regression assumption has not been violated.

Snapshot 5.2 Chi-Square Table 27

Distribution Plot
Chi-Square, df=1 1.6 1.4 1.2 1.0 0.025

Density

0.8 0.6 0.4 0.2 0.0 0.0009821 0 0.025 X 5.024

Graph 5.2 Chi-Square Distribution Plot

5.3 Serial Correlation

One of the assumptions of regression was that the random errors are independent of one another. Since the event study in this assignment conducts time-series analysis, it is likely that the error term is a representation of all economic, business and market factors and not only the independent variable. It is therefore possible that these factors behave in the same manner and the error terms are correlated with each other. Once again as with the case of Homoscedasticity, if the assumption of independence of error terms is violated, the coefficients determined and the hypothesis tests carried out could be biased. Graphical methods can be used to test autocorrelation; however a more popular method is a technique referred to as the Durbin-Watson test. The attempt is to find out whether the error terms are autocorrelated as shown in the formula (26).

Hence the Null hypothesis at 5% level of significance is:

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In the Durbin-Watson model the t-statistic d, is calculated as: Which is approximately equivalent to:

Where: r = the sample estimate of the population correlation between adjacent errors Since the correlation can always be only between +1 and -1, then Durbin-Watson statistic is always between 0 and +4. The decision rule for the Durbin-Watson test is as follows: 1- Reject H0 if 4 dL< d < dL. 2- Fail to reject H0 if dU < d < 4 - dU 3- The test is inconclusive if dL < d < dU or 4 dL > d > 4 dU. Using Minitab the Durbin-Watson result is worked out 2.04487.

Snapshot 5.3 Durbin-Watson using Minitab 29

By referring to the Durbin-Watson table with n=239, k=1, and =0.05 the dL and dU are found to be 1.65 and 1.69 respectively. Since dU < d < 4 - dU, we are unable to reject the Null hypothesis at 95% level of confidence, which means there is no serial correlation between the error terms.

6. Testing Coefficient Stability

This study conducts a time-series analysis with the assumption that the data are stationary and the regression coefficients remain stable throughout the whole period. If however this is not the case, then the residual analysis above will be of limited accuracy. Inevitably there will be an element of error when estimating the and parameters, however if these coefficients consist a high percentage of the error then our regression model in calculating the abnormal returns is inefficient. In order to test the coefficient stability an F-test known as the Chow Test can be used as shown by formula 29.

P is the pooled sample of the 239 days estimation period previously used for estimating the Market Model. The chow Test attempts to determine whether the improvement in fit when breaking the pooled sample into two subsamples of A and B is significant at 95% level of confidence. The 239 days can be broken into 120 and 119 days

subsamples and 3 regressions need to be performed for P, A and B. The results are shown in the snapshots below.

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Snapshot 6.1 ANOVA P

Snapshot 6.2 ANOVA A

Snapshot 6.3 ANOVA B

Using the information in the above tables:

This result simply means that the Null hypothesis that the improvement in fit is not significant cannot be rejected at the 95% level of confidence, indicating that in the specified 239 days the coefficients can be thought to be stable.

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7. Limitations and Conclusion

The analysis in this study indicated that the four chosen events did not cause BT to generate abnormal returns. It is however important to highlight that there were many issues in conducting this study. The parameters of the Market Model were estimated based on the OLS regression, which requires several conditions to be met for the model to be unbiased and efficient. Due to constraints set upon this assignment many of these issues were not examined. There are many other models for measuring the abnormal return, most of which use different variations of the asset pricing model such as the Fama-MacBeth residuals and control portfolios. Using alternative models could be of more benefit, require less stringent assumptions and give results which are substantially different to the ones obtained. It is important to consider whether a one-factor model, could result in what is referred to as Omitted Variable Bias. This simply means an important variable was omitted from the model, which led to inaccurate results. The estimation period chosen is somewhat biased. Although it is close to the first event, it is distant to the final event. A better choice of estimation period could be one including all the days between testing periods for each event. Chow test functions satisfactorily when the date of a structural break in the time series data can be specified. In the above analysis the subsamples and the break were chosen at random. Since the break date is not known with certainty a test such as QLR (Quandt Likelihood Ratio) maybe more appropriate.

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A limitation of this study was merely due to its nature. The literature is filled with event-study methodologies conducting cross-sectional analysis, whereas in this assignment the effect of events were studied throughout a period of time, hence there is the question of reliability of some of the models used.

It can be concluded that although there were many limitations to this study, there is no evidence that the use of more sophisticated models would have conveyed any benefits; however some of the above limitations could be adjusted in order to obtain more accurate results.

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8. Bibliography

Brealey, R. A., Myers, S. C., & Allen, F. (2008). Principles of Corporate Finance (9th ed.). New York: McGraw Hill. Brown, S. J., & Warner, J. B. (1980). Measuring Security Price Performance. Journal of Financial Economics, 205-258. Brown, S. J., & Warner, J. B. (1985). Using Daily Stock Returns: The Case of Event Studies. Journal of Financial Economics, 3-31. Dougherty, C. (2011). Introduction to Econometrics (4th ed.). Oxford: Oxford University Press. Dyckman , T., Philbrick, D., & Stephan, J. (1984). A Comparison of Event Study Methodologies. Journal of Accounting Research, 22, 1-30. Miller, M. (2012). Mathematics and Statistics for Financial Risk Management. New Jersey: John Wiley and Sons. Mukhtar, A. M., & Subhash, C. S. (1993). Robustness to nonnormality of the Durbin-Watson test for autocorrelation. Journal of Econometrics, 117-136. Mukhtar, A. M., & Subhash, S. C. (1996). Robustness to nonnormality of regression F-tests. Journal of Econometrics, 175-205. Newbold, P., Carlson, W. L., & Thorne, B. (2003). Statistics for Business and Economics (5th ed.). New Jersey: Prentice Hall. Ruback, R. S. (1983). The Cities Service Takeover: A Case Study. The Journal of Finance, 319-330. Stock, J., & Watson, M. (2008). Introduction to Econometrics, Brief Edition. Boston: Pearson Education. Strong, N. (1992, June). Modelling Abnormaln Returns: A Review Article. Journal of Business Finance and Accounting, 19(4), 533-553.

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9. Appendix
9.1 The Discussion of the Events
28/09/2011 - It had been reported that BT had a stake of more than 20% in Tech Mahindra, an Indian provider of IT and networking technology, and had been attempting to sell its Stake in Tech Mahindra gradually over the years. This event is of high importance as BT was one of the major clients of Tech Mahindra, which provided technology services to global telecoms operators. Upon the release of the news, Reuters reported that BTs exit from Tech Mahindra is likely to cloud the outlook for future contracts from BT. (Reuters, 2012) 11/01/2012 - BT Group PLCs British Telecommunications plc announced a four-year networked IT Services contract with Staples. Staples, is an office products supplier company that serves businesses and consumers in 26 countries, in the four continents of America, Europe, Asia and Australia. During a press release, Edwin Hageman Benelux, the ex-CEO of BT shared his belief, that the announcement of this contract will have a positive impact on BTs Reputation as it confirmed BTs strength in delivering international networked IT services. (Reuters, 2012) 07/03/2012 - BT Group PLC announced that it has signed a five year outsourcing deal with Standard Life, a long term savings and investment business. The 30 million dollar contract was for BT to manage Standard Lifes communications infrastructure. 01/06/2012 - BT Group PLC announced the sale by Global Services of its French application development services business to the publicly listed French IT services
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company Osiatis. The sale which was effective on the same day was to help BT Global Services in France to focus further on its core strategy, offering networked IT services and communications solutions to corporate customers and the government sector. Although the importance of these events was justified and the possible impacts that their disclosure were to have on BTs return been discussed, no inferences can be made without a thorough analysis using sound statistical tools.

9.2 Alternative Benchmarks for Abnormal Returns

Except for the case of CAPM model11, these return generating models all estimate the abnormal return (i.e. error term) using: ( )

Where:

Mean Adjusted Returns The mean adjusted return is a nave model in which the predicated return is a constant, calculated by averaging the historical returns without taking into account market-wide

11

If is replaced with the risk-free rate and Rm with the Market Risk Premium (RM Rf) then in a way it can be said that the residual or abnormal return of the CAPM model also follows suit with formula (1).

36

factors and the company-specific risk. It is equivalent to formula (29) when is the mean historical return of the estimation period, and is set to zero.

Market Adjusted Return In this model, the expected return for a security is equal to the market return for that period. At any single point in time the return across securities is a constant. It is equivalent to formula (29) when is zero and is 1. Market and Risk Adjusted Returns This model uses the CAPM model as its benchmark. It takes into account both the security and market risk. The ex-ante return is calculated as follows: ( Where: ) ( )

The ex-ante abnormal return is calculated by the difference between the actual returns of the security j and the expected return calculated by the CAPM model. [( ) ]

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9.3 Estimation of Equity Beta for the CAPM Model

A companys equity Beta can be estimated simply by regressing its returns against the returns of a market index and is then simply calculated as follows:

However a firms equity Beta is not just the function of its business risk but its capital structure and the projects it undertakes. For instance a firm with higher debt financing will have a higher equity Beta. A post event-window could help this analysis as the capital structure of BT post these events may have altered. Since the companys Beta is also dependent on its capital structure the Equity Beta could be obtained using the below relationships.

)]

The Asset Beta can be obtained by the pure-play method which means the Asset of a similar publicly traded company in the same line of business, and underlying projects can be adopted.

9.4 The Three-Factor Model

A possible improvement to the Market Model could be the Fama and Frenchs threefactor model, which has been derived from the Arbitrage Pricing Theory (APT). Fama

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and French observed that small firms with high book-to-market ratios have provided above-average returns. Furthermore there have been many occasions where the firm size and the book-to-market ratio where shown to affect the firms profitability, as investors want to get compensated for exposure to these factors.

( (

) )

9.5 Goodness of Fit: The F-Test

In order to test whether the R2 of 0.475 obtained in section 4.2 reflects a true relationship, the F-test can be used. The Null and alternative Hypothesis as before are H0: =0 and HA: 0 at 95% level of confidence.

Where k is the number of parameters and n is number of observations in the sample.

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As it can be seen the F-test is 213.336. By looking at the F-table, the critical value of the F-test for 5% level of significance, where k 1 = 1 and n k = 237 is 3.88. Hence the Null hypothesis gets rejected once again, confirming the existence of a relationship between the regressand and regressor.

9.6 Non-Parametric Significance Test

When using the t-statistic for the event study analysis it is important to bear in mind that there are some assumptions implicit in this methodology. If these assumptions are violated, then the inferences based on them could be of limited accuracy. For instance if the sampling distribution of the t-statistic used for hypothesis testing differs from that of the actual distribution, the frequency of type I errors (rejection of the Null hypothesis when its true) may be increased by more than the level specified by the significance. Brown and Warner noted that the sign test and Wilcoxon signed rank test are most widely used when conducting event-study. In the sign test, after the residual returns with value of zero are discarded, the hypothesis at 95% level of confidence is as follows:

The Null hypothesis states that there is no evidence that BT generated abnormal return, since the number of positive and negative residuals in the testing period is equal. The alternative hypothesis on the other hand suggests that the positive observations are more or less than one half, hence there has been abnormal performance.
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The test statistic for a sign test is simply the number of positive residuals.

Table 9.1 Sign Test

The p-value12 for the sign test is calculated using the cumulative binomial distribution in Minitab.

Snapshot 9.2 Calculating P-value using Minitab

12

The p-value is the smallest level of significance at which the Null hypothesis can be rejected.

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9.7 Calculation of Prediction and Confidence Intervals

By referring to section 4.2, the confidence interval for BTs slope can be estimated using the relationship (36).

SPSS is capable of calculating the confidence interval as shown in the below snapshot.

The Confidence interval of E(RBT(t)|RFTSE(t)) is calculated using formula (37). ( )

The Prediction interval on the other hand is calculated as shown in the formula (38). ( )

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9.8 Extreme Outliers

The Regression like mean and median can be affected heavily by extreme outliers. The extreme outliers may have led to an inaccurate estimate of the Market Model parameters. Not all outliers result in biased estimates. However, an outlier which has a big enough effect on the OLS regression line is referred to an Influential Point. A good way to diagnose this is to plot a scatterplot of the error terms against the independent variable. There should not be any increased or decreased changes in the residuals as the independent variable increases.

Scatterplot of Error Terms vs FTSE Returns

7.5

5.0

Error Terms

2.5

0.0

-2.5

-5.0 -5 -4 -3 -2 -1 0 FTSE Returns 1 2 3

By looking at the graph above, there appears to be no visibly obvious changes or patterns in the residuals as the independent variable increases. Hence whilst there are possibly some outliers in the data, this does not mean that they would influence the regression line.

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9.9 Remedies for Heteroscedasticity

Fortunately in the regression equation obtained in this assignment the assumption of homoscedasticity was met, so no adjustments were necessary. However, if this was not the case, one way of fixing this issue was by performing Weighted Least Squares (WLS). Recall the simple linear regression relationship between FTSE and BTs returns.

Assume the standard deviation of the error term on day t is

. The days

has the

smallest values, gives the most accurate results regarding the relationship between RBT and RFTSE and hence more weight should be given to these days observations. Another methodology is to assume that for the standard deviation of the error terms for each day, there is a variable Z that is proportional to .

Where

is a constant

Dividing equation (39) by will give relationship (40).

This relationship is homoscedastic as the population variance is constant as follows:

By regressing

against

the issue of heteroscedasticity is resolved.

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9.10 Binomial Distributions Methodology

In conducting the hypothesis test using non-parametric approach, the p-values were calculated in order to reach a decision regarding the Null and alternative Hypothesis. However, due to the word limit, the methodology was not explained and the results were simply drawn from Minitab. In the Sign test, n was the number of nonzero residuals and S the number of positive differences. In the Sign test for the two-tailed hypothesis test the p-value is 2(p-value). The calculation will be shown for event 4 where S=3 and n=11.

Where:

P(x=r) is a binomial distribution and is calculated as shown in the relationship (44). ( )

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