D ISTRIBUCIÓN DE TRENES ASIGNADOS INDIRECTAMENTE

Studies outlined so far share theoretical foundations with the dissertation at hand. The new aspect of this dissertation is that it combines the theoretical framework on neglected stocks with investors’ considerations on terror-free investing. This is why it is also related to re- search on terror and its impact on financial markets. This latter field of research is fairly new as most studies have been published in very recent years. In a review of the literature in this

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field, Karolyi (2006, p. 14) contends that “... we still know relatively little of the economic and financial consequences of terrorism...”

One of the first studies on the effects of terrorism on financial markets is Abadie and Gardeazebal (2003). In a case study setup, the authors investigate the economic consequences of Euskadi Ta Askatasuna’s (ETA) terrorism directed at the Basque country. First, they in- vestigate the impact of terrorism on GDP. To this end, they form a synthetic Spanish control region resembling the Basque country on major economic characteristics. This synthetic re- gion (consisting of Catalonia and Madrid, while most of the weight is put on Catalonia), dis- played a GDP growth path similar to that of the Basque country during the 1960’s. When ETA started implementing large-scale terrorism activities in the mid-1970s, the Basque coun- try and the control region started to display remarkable discrepancies in GDP growth. In fact, the difference in per capita GDP between the two regions averages 10% during the subse- quent 20 years. Furthermore, fluctuations in this gap are shown to be related to terrorist activ- ity. Second, the authors investigate terrorism’s impact on firms with involvement in the Basque country. As the ETA announced a cease-fire in September 1998, firms with major involvement in the Basque country should have profited from improved business conditions. This is why stock prices of these firms should have increased in response. Similarly, when the ETA declared the cease-fire’s end in November 1999, stock prices of the same firms should have decreased. Consistent with the authors’ expectations, the control portfolio of firms with little business activities in the Basque country displayed a short-term return per- formance inferior to the one of the portfolio consisting of firms with high activity in the Basque country during the time the cease fire was declared. When the ETA declared the cease-fire’s end, short-term return performance of control firms was superior.

In a study covering a time period of 86 years, Chen and Siems (2004) use an event-study methodology in order to assess the short-term impact of terrorist attacks on capital markets.

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In total, the authors analyse 14 events starting with the sinking of the luxury ocean liner Lusi- tania, torpedoed on May 7th_{, 1915, and ending with the September 11}th_{, 2001 terror attacks} (9/11). First, they analyse these events’ effects on the US equity market. In twelve out of 14 cases, stock markets displayed a negative reaction to terrorist attacks. The first of the authors’ two main findings is that in earlier years, negative effects tended to prevail for a longer peri- od of time after the actual event. Of the four incidents until 1950, three incidents caused sig- nificantly negative reactions of the Dow Jones Industrial Average (DJIA) in the eleven day event period ending ten days after the actual event. In contrast, only one out of ten incidents in the post 1950s period yielded abnormally negative DJIA reactions in this long event period. The authors attribute this finding to increased market efficiency in later years and to dedicat- ed stability measures that were undertaken only in more recent years. The second main find- ing is that of higher resilience of US capital markets when compared to other local equity markets. In comparison to many other local markets, US equity markets recovered more quickly, i.e. the negative short-term stock price effects were less persistent than in other mar- kets. As the authors reason, this latter finding is most likely attributable to the strong bank and financial trading sector in the US. Furthermore, Chen and Siems (2004) obtain evidence consistent with the notion that nowadays, global capital markets are tightly interlinked. Fol- lowing the August 2nd, 1990 invasion of Iraq in Kuwait and 9/11, global capital markets all displayed a substantially negative reaction.

In a similar vein as Chen and Siems (2004), Johnston and Nedelescu (2006) aim to shed light on institutional aspects of financial markets’ reaction to terrorism. While Chen and Siems (2004) present cross-sectional differences in international financial markets’ ability to recover from terror events, Johnston and Nedelescu (2006) are engaged in finding out about the policy and regulatory means that help financial markets absorb shocks to such unantici- pated events. For this purpose, they review capital markets’ reaction to 9/11 and to the March

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11th, 2004 attacks in Madrid. The study’s empirical part is solely descriptive in nature, as the authors draw on previous studies (e.g. Chen and Siems, 2004) in demonstrating the sequence of events and their consequences. In addition, the authors offer a detailed explanation of the crisis management measures that were undertaken in order to make capital markets recover. While such measures were not necessary in the case of the attacks in Madrid, efficient re- sponse of regulatory bodies helped financial markets rebound in the case of 9/11. In conclu- sion, the authors take sides with Chen and Siems (2004) in emphasising the critical im- portance of “diversified, liquid, and sound (...) financial markets”. Moreover, they deem “timely and flexible response of the competent authorities” crucial (Johnston and Nedelescu; 2006, p. 23). This conclusion does not really follow from the example of the attacks in Ma- drid, where policy and regulatory intervention was neither observed nor regarded as helpful by the authors.

In a brief study on the impact of terrorism on six equity markets, Arin et al. (2008) find terror causes stock prices to decrease and volatility of returns to increase, regardless of the market under investigation. Of the six markets they analyse, the two European markets (Spain and the UK) display the weakest reaction to terror events. This is consistent with pre- vious studies by Chen and Siems (2004) as well as Johnston and Nedelescu (2006) who find markets with higher institutional quality to display a higher level of resilience.

The study of Arin et al. (2008) is a little at odds with a similar one conducted by Nikkinen et al. (2008). In the latter study, the authors investigate the impact of 9/11 on stock returns and volatility. They confirm results of previous studies in that they find the event to have induced negative short-term stock price reactions and an increase in return volatility. In con- trast to Arin et al. (2008) and other studies, their evidence indicates less sensitivity to the event for less integrated markets.

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Yet another study on 9/11 exclusively focuses on this event. Carter and Simkins (2004) investigate the incident’s impact on the returns of airline stocks during the period after the event. They are especially concerned with the question of whether investor reaction to the event can be considered rational. While they suppose the emotional nature of peoples’ reac- tion might have caused them to engage in panic selling, their evidence does not support this presumption. In fact, the terror attacks resulted in significantly negative abnormal returns for each of the sample airlines. Because the authors further reject the hypothesis that the negative reaction was of the same magnitude for all firms tested, they infer that the market rationally incorporated information. When they analyse the determinants of abnormal returns, they find additional evidence for this interpretation. Negative reactions were stronger for firms that were less equipped with cash and cash equivalents. This is consistent with the notion that investors feared some airlines would not be able to meet their short-term obligations.

A very similar study (Drakos, 2004) also analyses the impact of 9/11 on the airline indus- try. The author finds the attacks to have caused a structural shift in systematic risk as meas- ured by the beta coefficient. When he decomposes total risk as measured by stock return volatility into its systematic and idiosyncratic component, he finds both risk types to have increased.

Yet another study by Drakos exhibits a link to Carter and Simkins (2004). In Drakos (2010), the author investigates psychological effects in the context of terror incidents and subsequent stock market reactions. In that Carter and Simkins (2004) are engaged in finding out whether the market rationally prices terrorism-related information, the two studies are related. Interestingly, Drakos (2010) finds that stock market reactions to terror events are stronger in cases where the psychosocial impact (as measured by “tangible changes in behav- iour” like “symptoms of Post-traumatic Stress Disorder”: Drakos; 2010, p. 131) of such events is more pronounced. Thus, the study implicitly rejects Carter and Simkins (2004) in-

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terpretation of stock markets reacting rationally to terror events. However, the reason for the studies’ diverging interpretations of investor behaviour is not based on diverging empirical evidence. As a matter of fact, both studies find terrorist events to cause negative short-term stock price reactions. Rather, the divergence is inherent in the authors’ interpretation of ra- tionality. While Carter and Simkins (2004) infer rationality from the observation that nega- tive returns of sample firms vary in magnitude and are explainable by the differing degrees to which sample firms were equipped against short-term financial distress, Drakos (2010) inter- prets capital market reactions to terror events as principally incommensurable with rationality. Under the null of market efficiency, as he asserts, such events should not at all have an im- pact on stock returns.

Eldor and Melnick’s (2004) study focuses on the Israeli stock and foreign exchange mar- ket. In a period of investigation encompassing 13 years, the authors identify a total number of 639 terror attacks. Each of the incidents is characterised along the dimensions location, target, type of attack and number of casualties. The authors aim to find out whether those determi- nants have an impact on financial markets’ reaction. The most pervasive effect is found for suicide attacks and attacks in which the number of victims is high. The stock market as well as the foreign exchange market both display considerable sensitivity to these parameters. In contrast, location of an attack does not have an influence on either of the two capital markets under investigation. An interesting side aspect of the Eldor and Melnick (2004) study is the question of whether markets become insensitive to terror attacks over time. As terror attacks are a recurring phenomenon in Israel, markets might expect a certain number of incidents and internalise the information. Results indicate no such desensitisation of Israeli capital markets. Apart from kidnappings, the market’s reaction to the first of a series of similar events is not more pronounced than for subsequent events.

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Karolyi and Martell (2010) analyse the stock return impact of 75 terror attacks against 43 firms during the period between 1995 and 2002. Unlike higher level incidents such as 9/11, the incidents investigated in Karolyi and Martell (2010) are all directed towards individual firms. Overall, the authors detect significantly negative abnormal returns on the day of the events. They employ a cross-sectional analysis of abnormal returns in order to obtain insights about the determinants of abnormal stock price reactions. Evidence indicates that negative abnormal event day returns are more pronounced in wealthier and more democratic countries. Furthermore, when the terror incident is a kidnapping, negative reactions are of higher mag- nitude. In addition to Eldor and Melnick (2004), Karolyi and Martell (2010) is the second study to document the special role of kidnappings among terror events. After all, human capi- tal damage is perceived as more severe than losses of physical assets.

Brounen and Derwall (2010) analyse 31 terror attacks between 1991 and 2005 and their impact on eight developed financial markets. Organisations responsible for the attacks in- clude the ETA, the Irish Republican Army (IRA), Al-Qa’ida and others. For the day of the terrorist event, the authors detect a statistically significant, negative abnormal return across the sample. However, the effect’s magnitude is diminished by approximately one third when 9/11 is excluded from the analysis. After excluding this extreme event, the negative abnormal event day return loses its statistical significance. As a control, the authors investigate the ef- fects of earthquakes on financial markets. Since earthquakes are just as unanticipated and catastrophic as terrorist attacks, these two types of events share many characteristics but the terror dimension. The authors find earthquakes not to cause any abnormal event day return reactions. In an additional analysis, Brounen and Derwall (2010) find that when adjusting for systematic risk differences across industries, terrorist events have little impact on short-term stock price movements. As in the previous analysis, the authors find 9/11 to have caused se- vere negative stock price reactions, even after accounting for industry variations in systematic

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risk. Interestingly, Brounen and Derwall (2010) obtain evidence consistent with the notion that 9/11 induced a change in systematic risk. In the period after the attacks, most industries under investigations displayed higher beta coefficients than before 9/11.

In a broad study on terrorism and its impact on financial markets, Chesney et al. (2011) extend existing research by not only analysing the equity market, but also bond, commodity and gold markets. The authors also compare the effects of terrorism to other extreme events. In their case, these extreme events are financial crashes and, as in Brounen and Derwall (2010), natural catastrophes. As it was found in prior studies, Chesney et al. (2011) find terror events to cause stock markets to drop. They further detect substantial inter-industry differ- ences regarding the sensitivity to terror events. Some industries’ reactions to natural catastro- phes and financial crashes are in fact similar to the reaction to terror events. Since commodity, gold and bond markets do not consistently display a negative reaction to terrorist events, they can at least partially be regarded as a potential hedge against terrorism risk on the equity market. Interestingly, the authors find the point in time at which markets recover from cata- strophic events’ to differ from the point in time at which they recover from terror events and financial crashes. Consistent with prior work, the authors find markets to recoup quickly after terror events and financial crashes. In contrast, catastrophic events are often priced in the event’s aftermath.

Karolyi (2008) intends to find out whether terror-related considerations are priced in equi- ty markets. The study consists of two analyses. First, the author aims to find out whether ter- ror-related risk of a firm translates into a priced risk component and therefore increases a firm’s cost of capital. Second, he aims at investigating the risk and return consequences of terror-free investing (abstaining from investments in companies with operations in countries designated as State Sponsors of Terrorism by the U.S. Department of State). With respect to the first analysis, Karolyi (2008) calculates terror exposure scores for each firm in the S&P

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500 as a proxy for terror-related risk. Exposure scores are high, if a firm has operations in many countries that are frequently subject to terror attacks. Depending on the data source, either India or Iraq is the country with the largest number of terror incidents. Operations in these countries do therefore increase a firm’s exposure score. If a firm has a substantial part of its business in such high-risk countries, its raw exposure score is high. In addition to the raw measure, the author also calculates exposure adjusted by the respective firm’s interna- tionalisation. Therefore, the adjusted score measures the relative degree to which a firm’s revenues depend on geographic markets which are frequently subject to terrorist attacks. For the purpose of performance measurement based on exposure scores, Karolyi (2008) builds portfolios of stocks with high exposure scores (raw as well as adjusted) and portfolios con- sisting of stocks associated with low terror exposure scores (raw as well as adjusted). All portfolios deliver mildly positive alphas estimated by means of a four-factor model. Most importantly, the spread portfolios of highest minus lowest exposure do not yield economical- ly sizeable or statistically significant four-factor alphas. Hence, the author concludes that ter- rorism-related risk is not priced by financial markets. An aspect that warrants some consider- ation is revealed in the robustness checks. Karolyi (2008) finds that the portfolio of low expo- sure firms experience a substantial increase in systematic risk exposure around oil price shocks, while the portfolio of high exposure stocks does not. He attributes this to the fact that a lot of firms in the high exposure portfolio are international oil producers operating in re- gions of augmented instability. These firms are thus hedged against oil price shocks. This assertion is incompatible with the author’s prior statement of “the portfolios used in the study (...)” being “(...) similarly distributed across industries” (Karolyi; 2008, p. 113). In fact, port- folios seem to vary with regards to their industry composition at least in the case of the oil and gas industry. This casts doubt on the notion that the four-factor model used in the analy- sis of abnormal returns is sufficient to grasp risk differences among the portfolios. Augment-

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ing the model with an industry factor would have eliminated an industry-bias and could po- tentially have changed the results.

As mentioned above, Karolyi (2008) also investigates the risk and return characteristics of terror-free investing. If an investor wishes to implement such a strategy, he may consider the entire investment universe of stocks but stocks of firms with operations in countries designat- ed as State Sponsors of Terrorism. In the Karolyi (2008) study, the author considers the S&P 500 universe and excludes stocks of firms with operations in one of the potentially terror- supporting countries. As he mentions, this analysis is confined to US firms, only. As com- pared to non-US firms, US firms face tougher legislation with respect to activities in these countries. Therefore, very few US firms are active in such countries in the first place. This is why a terror-free investment strategy based on the S&P 500 excludes only very few stocks from the investment universe. Similar to the case of the terrorism exposure based investing strategy, results do not indicate performance differences between the terror-free strategy and a normal strategy. Four-factor alphas are again mildly positive for both strategies, with spread portfolio returns (terror-free minus full S&P 500) which are small in economic magnitude and statistically indistinguishable from zero.

In the author’s concluding remarks, he again reveals the study’s limitation due to its exclu- sive focus on the S&P 500 investment universe. As stated, the vast majority of firms operat- ing in countries designated as State Sponsors of Terrorism are non-US firms. This and the fact that public and private pension funds may have substantial holdings in those foreign firms lets the author conclude that research on terror-free investing incorporating a global investment universe warrants further investigation.

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