Deconstructing market responses

Abstract

PurposeThe aim is to present, explain and illustrate an improved method for decomposing an event‐based change in market value into its cash flow and risk elements.Design/methodology/approachThe approach is two‐fold. There is an algebraic comparison of the existing and improved decomposition to prove and delineate the benefits of the new method. There is an event study, using 130 firms, contrasting the results of the existing and improved methods.FindingsThe new, alternative method of decomposition is easier to use, provides a cleaner delineation of the components, and results in increased statistical significance in tests.Research limitations/implicationsResearchers now have access to an improved methodology for decomposing market value changes. Explicit limitations reveal when the new method provides benefits over the current method.Practical implicationsManagers considering strategic decisions now have an improved method to understand the main impacts on market value. For example, by decomposing the market's reaction to an acquisition announcement, managers can gauge better whether following through that decision is likely to have intended effects on the firm's cash flow and risk profile.Originality/valueThe value of this paper is the presentation of an improved method for event‐study type research, where delineation of the basis elements of changes in market value is required. Originality lies in the use of implied standard deviation (ISD) as an even more focused way to apply this new method when the target firms regularly trade financial options.