Model Specifications for Normal (or Expected) Returns

For corporate finance event studies that look into abnormal returns, robust model specifications for normal (expected) returns are needed. However, to verify the model specifi-cation, one needs to be cautious about the included explanatory variables. Although many candidate variables seem useful in forecasting the returns, they are not necessarily genuine systematic variables that explain the capital market equilibrium. Common-sense reasoning may be considered for filtering the returns thoroughly with all seemingly significant variables to provide cleaner abnormal returns. Yet, inclusion of nonsystematic firm-specific variables in the expected rates of returns may, in fact, result in incorrect conclusion due to possible overrejection in statistics applied. This chapter introduces some new arguments for specification of normal returns.