Literature review

Literature on political risk and financial markets has tended to focus on events that signal political risk and analysed how they have affected exchange rate movements and equity markets in terms of both return and volatility. Indeed, Kim and Mei (2001) suggest that political events are the most important, or at least the most common factors that influence stocks in Hong Kong.

They employ a GARCH ‘components jump volatility filter’ to identify dates where the Hang Seng Index undergoes sharp adjustments before relating these ‘jumps’ to prevailing events, observing a close relationship between these ‘jump dates’ and political news. Additionally, Voth (2002) finds that between half and two-thirds of stock market volatility during the Great Depression in Western Europe was due to political uncertainty, emphasising that the Russian Revolution occurred just over a decade beforehand and that investors were particularly sensitive to the potential consequences of political risk, following the impacts of communism for private ownership.

Although small, a body of literature that specifically studies the relationship between political risk and financial markets through unanticipated acts of violence does exist. For example, Zussman and Zussman (2006) indirectly assess the effectiveness of Israeli counterterrorism policy through an event study by considering stock market responses to the targeted assassinations of Palestinian terrorist leaders since 2000. They observe no effect until separating the targets into military and political leaders, finding that the assassinations of political leaders resulted in a 1 percent loss for investors in equity, on average, while assassinating military leaders led to gains of between 0.5 and 1 percent in the immediate aftermath. Zussman and Zussman (2006) therefore conclude that political assassinations are perceived as counterproductive for counterterrorism by investors, but military assassinations do seem to be effective. This distinction is probably because military assassinations impede military capabilities while political assassinations may provoke retaliation.

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More recently, Incerti and Incerti (2019) examined the stock market impacts of

‘irregular’ regime changes – namely coups, assassinations and resignations – in a global event-study setting since 1901. Using an event event-study approach, they detect positive impacts from resignations of about 4%, which persist for approximately two months, on average; but negative returns after coups and assassinations of about 2%, lasting approximately six months.

The cases of Pakistan and the Arab Spring have also received some attention in the contexts of stock markets. Mahmood et al. (2014) and Nazir et al. (2014) both used event studies and found that a variety of political events and acts of violence from 1998 to 2013 and 1999 to 2011, respectively, had negative impacts on the Karachi Stock Exchange and resulted in increased volatility. The magnitude of these impacts also depended on the types of events that occurred. Likewise, Chau et al. (2014) and Abdelbaki (2013) found negative return and increased volatility effects on Middle Eastern and North African stock markets following uprisings and protests during the Arab spring. They used GARCH methods and VECM models with impulse response functions, respectively. However, Chau et al. (2014) only found large impacts for Islamic stock indices (“Shariah-compliant Islamic financial assets”) and little or no effect for conventional stock market indices, emphasising the roles of investor expectations and ideology.

Departing from the literature on the stock market impacts of political risk, Fatehi (1994), recognising the challenges in quantifying political risk, proposed that capital flight could be used as a simple but reliable proxy. In his paper, he uses regression analysis with lags to detect the effects of various sources of political instability, including political assassinations, on capital flight from 17 Latin American countries to the US between 1954 and 1982. Although these results were rather heterogeneous, many indicators – including political assassinations – had robust impacts with response times in excess of a year. Similarly, as part of a study to determine whether exchange rate uncertainty and socio-political instability, both individually

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and jointly, affect private investment in eight Latin American countries from 1975 to 1999, Escaleras and Thomakos (2008) also find that socio-political factors have lasting impacts on exchange rate uncertainty, persisting for a year or longer. However, the effect of assassinations is insignificant once riots and violent demonstrations are controlled for. More directly, Bouraoui and Hammami (2017) examine exchange rate volatility using a political instability index derived from events such as terrorist attacks, labour strikes, violent protests and political assassinations in five Middle Eastern countries during the Arab Spring. They use autoregressive distributed lag (ARDL) and vector auto-regressive (VAR) models with impulse response functions, finding elasticities of between 0.13 and 0.36, depending on the country. These impulse response functions indicated that the effects last between 12 and 18 months.

There has not been much research on the impacts of political risk on bond markets, but Oosterlinck (2003) finds that only political factors caused structural breaks in French bond yield series during World War II. Additionally, Ferguson (2006) found that European bond yields were sensitive to political events between 1843 and 1880, but this was no longer the case between 1881 and 1914.

Overall, literature on the effect of political risk on financial markets seems to show that investors respond by disinvesting in equity and then either by moving their holdings to bonds or else more stable destinations offshore.

D.3. Data

The assassination data for this paper come from the Global Terrorism Database. The database provides detailed information of over 190,000 violent events, including 20,000 assassinations from around the world since 1970. The Oxford Dictionary (2019) defines an assassination as the “murder [of] (an important person) for political or religious reasons”, necessitating that this paper use a subset of the database in order to adhere to the problem of

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political risk. As such, only the assassinations of members of ‘general government’ and

‘diplomatic government’ are included, while categories such as religious, business, police, journalistic or military assassinations are excluded. After matching the assassinations with the financial data, 1,767 cases across 107 countries remain.³⁹

The financial data come from the Globaӏ Financiaӏ Database. The database affords centuries of financial and macroeconomic data at various geographical and administrative levels and at various periodicities. For example, United Kingdom’s FTSE All-Share Return Index extends back to 1694 on a monthly basis, with daily data available since 1964. However, since most series are not available at daily periodicities globally and since 1970, monthly data is used. Additionally, all financial series under study are inflation adjusted, in order to examine the real impacts of political risk.

The first of the financial series utilised to investigate the impact of political risk is the total return on equity holdings from the largest stock exchange within each country. This is defined as the monthly equity return after all dividends are assumed to be reinvested, as calculated in equation 1. Since the research question here is whether investors move their holdings from equity to short term bonds in uncertain times, despite the political nature of the risk, this is a natural point of departure. Regardless of how investors choose to reallocate their holdings in response to political risk, a negative impact on equity return is expected.

𝑇𝑜𝑡𝑎𝑙 𝑆𝑡𝑜𝑐𝑘 𝑅𝑒𝑡𝑢𝑟𝑛_𝑖𝑡 = (𝑃_𝑖𝑡− 𝑃_{𝑖,𝑡−1}) + 𝐷_𝑖𝑡

𝑃_{𝑖,𝑡−1} (1)

Where P refers to stock price, D to dividends, i to each stock exchange and t to each month. After attempting to detect a departure from equity holdings, I examine the impact of assassinations on proxies of the risk-free rate. The risk-free rate is best approximated by

short-39 Note, the final sample sizes are greatly reduced, since only assassinations with valid (‘exogenous’) estimation windows are analysed.

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term bond yields; and by yields on Treasury bills in particular (Dimson et al. 2002). Therefore, the preferred risk-free rate proxy for this paper is the 3-month Treasury bill yield, since this is the shortest-term Treasury bill yield within the financial database. When unavailable, the risk-free rate series were supplemented by alternative short- or long term government bonds (these have also been widely used as risk-free rate proxies, e.g. Hodges et al. 1997; Mukherji 2011), or else central bank discount rates or interbank rates (used by Dimson et al. 2002) when they are closely related to Treasury bill yields in overlapping periods (e.g. figure A.D.1.). A negative impact of assassinations on bond yields implies an increase in demand for short-term government bonds, which would provide evidence of investors ignoring the political nature of risk in seeking the risk-free rate. Conversely, a positive impact on bond yields is associated with a decline in demand for short-term government bonds.

The next series under study is the equity risk premium, the theoretical ‘reward’ for incurring risk. This is a particularly interesting metric since it reflects the willingness of investors to maintain their level of exposure to risk, at least with regard to equities. The equity risk premium is also the best predictor of the prospective risk-premium, an important metric for estimating future returns, the cost of equity capital and company valuations (Dimson et al.

2002). This means that a negative impact on the equity risk premium following an assassination could signal a long run distaste for risk. Conversely, no significant impact on risk premium could indicate either that investors see the period of heightened risk as temporary, or that they are convinced of the persistence of the equity premium puzzle – that equity outperforms even its risk adjusted return – possibly as a result of habit persistence (Mehra and Prescott 1985;

Benartzi and Thaler 1995; Constantinides 1990).

The geometric risk premium is calculated here (equation 2), in accordance with Dimson et al. (2002). This has become standard in financial literature as using the arithmetic risk premium implicitly requires the assumption that the observations in the series are independent

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of one another (Lütolf-Carroll & Pirnes 2009). Since Fama and French (1986), Lo and MacKinlay (1988), and Porterba and Summers (1988) detect negative autocorrelation in stock returns – due to short term overcorrections – this is not necessarily the case and the geometric method should be used.

𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚_𝑖𝑡 = ( 1 + 𝑟_{𝑒𝑞𝑢𝑖𝑡𝑦,𝑖𝑡} 1 + 𝑟𝑟𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒,𝑖𝑡

) − 1 (2)

Then, as an alternative to the return on equity holdings, the impact of assassinations on the growth rate of market capitalisation is examined. In this way, a more precise impression of how investors change the proportions of equity in their portfolios can be obtained. Additionally, since the total equity return indicator from before includes dividend pay-outs and assumes that all dividends are reinvested, market capitalisation acts as an ideal robustness measure, as only dividends that are actually reinvested are appraised.

Lastly, the impact of assassinations on the real US dollar exchange rate for each country is investigated. The US dollar is used for comparison as it is the most traded currency globally and the most widely held reserve currency, while the United States is the world’s largest economy and the home of the world’s two largest stock exchanges by market capitalisation.⁴⁰ Real exchange rate responses to assassinations would provide a first clue as to whether investors have incentives to move their holdings abroad or else make local investments even more attractive than before. A full answer to this question would require a complete analysis of spillover effects, but simple changes in exchange rates guide intuition. A real depreciation relative to the dollar would indicate that international investors earn reduced returns, ceteris paribus, and make flights to safety more likely. Conversely, a real exchange rate appreciation increases returns for international investors, providing incentives to increase their holdings in local assets, ignoring the impact of political risk on those assets.

40 The New York Stock Exchange (NYSE) and the NASDAQ

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