THE ECONOMIC COST OF NUCLEAR THREATS: A NORTH KOREA CASE STUDY. Abstract: The purpose of this paper is to investigate how public announcements of a nation’s nuclear programme development influence neighbouring countries’ stock markets. The countries examined in this case study are North and South Korea. To test this relationship I conducted an event study using MacKinlay’s market model. Six announcement days were studied comprising out of three nuclear tests and three missile and satellite related tests. The findings of this research are in contrast to prior research. Empirical researches on the economic effects of terrorism suggest that acts of terrorism create large impacts on economic activity. The results of our event study show that the announcements caused both negative and positive reactions on the market. Author: Ryan McKee Student number: 6181066 Supervisor: Shivesh Changoer Date: 8th of Jan, 2014 ETCS: 12 INTRODUCTION Stock prices represent investor’s expectations about the future. News announcements effect these expectations on a day to day basis. Terrorist attacks, military invasions, nuclear threats or any other ambivalent events can alter investor’s expectations and so allow the prices of stocks and bonds to deviate from their fundamental value. Once such events have taken place investors often defer from the market in search of safer, more secure financial investments which can lead to panic and chaos on the markets (Chen and Siems, 2004). Such chaos can also be caused by threats from other neighbouring countries. A perfect example of this is the relationship between North and South Korea. Ever since the division of North and South Korea on September 8, 1945 the two bordering nations have had a strenuous relationship, ultimately leading to the Korean war of 1950-1953. Since then the two nations have technically still been at war although no actual acts of war have taken place. However, since 1991 North Korea has started developing its own nuclear programme and has threatened South Korea and her allies. Due to the severity of the threats (nuclear arms) North Korea has caused a widespread stir and predominately negative reactions in the international community. Since the beginning of North Korea’s nuclear programme in 1991, it has threatened South Korea on several occasions comprising out of seven verbal threats and three actual nuclear tests. The seven verbal threats occurred on October 17th, 2002, December 12th, 2002, January 10th, 2003, February 10th, 2005, May 11th, 2005, July 5th, 2006, and October 3rd, 2006. Actual tests were conducted on October 9th 2006, May 25th 2009 and February 12th 2013. All statements were publicly announced by North Korean state officials. The markets did not seem to respond to the seven verbal threats. The markets only seemed to react to the announcements on days which th actual nuclear testing occurred. This is especially noticeable on October 9 2006. The market pg. 2 experienced a sudden drop in value in correspondence with a depreciation of the won. However the market was quick to recover once news had come out that North Korea was not interested in starting nuclear warfare but rather signalling they were open to negotiations. This study examines how news announcements about nuclear warfare affect stock markets and in particular the South Korean stock market. Therefore the central question of this paper is: how do announcements of North Korea’s nuclear program influence the South Korean stock market? Although the media has frequently reported on the North Korea’s nuclear threat, there has been little investigation to the actual effects on financial markets. This article tries to shed a light on such effects. This paper adds to previous research by investigating how financial markets respond to the threat of nuclear attacks from other nations, such research is lacking in the current literature. This article is organized as follows. First I summarize the existing literature on trading styles and impacts of terrorism in section 1. Section 2 and 3 consist of the explanation of the empirical method used and provides a description of the data in the analysis. The empirical results are shown in section 4. Finally, section 5 provides a discussion and concluding remarks. pg. 3 LITERATURE REVIEW In recent years there has been an increase in interest on the macroeconomic effects of terrorist attacks. A terrorist attack is a form of an external shock to an economy. The threat of nuclear attacks or nuclear warfare can be seen as a similar form of external shock. Many studies conducting research on the effects of terrorism use reduced-form models to describe the impact of terrorist attacks on an economy. These studies show that terrorist attacks have a negative effect on economic activity (Blomberg et al., 2004; Tavares, 2004). A paper investigating the impact of terrorism on the behaviour of stock, bond and commodity markets around the world found that approximately two thirds of the investigated terrorist attacks lead to a significant negative impact on one of the markets. Drakos (2010) produces a similar paper in which he investigates the impact of terrorist activity on daily stock returns across a sample of 22 countries ranging from Asian, European and American. His employed methodology makes use of a flexible version of the World CAPM model. The research also focuses on how the psychosocial impact affects the stock returns. According to Edmans et al. (2007), theoretically, terrorism satisfies the criteria which are known to affect the moods of investors. The results show that terrorist activity indeed leads to significantly lower returns on the day a terrorist attacks occurs. He also finds that this negative effect is larger when the terrorist attacks cause a higher psychosocial impact. This shows how terrorism affects financial markets but also provides empirical evidence supporting the sentiment effect. There also appears to be a difference in impact across industries. The airline industry and insurance sector exhibit the highest vulnerability to terrorism while the banking industry is the least sensitive. According to their analysis the impact on the aero/defence, pharma/biotech and oil/gas sectors are both positive and negative (Chesney, Reshetar, Karaman, 2011). In their paper pg. 4 they use an event study methodology. They estimate the daily excess returns by using the mean- adjusted-returns approach. For their longer event windows they also compute the cumulative average returns. They computed the statistical significance by using the test statistics described by Brown and Warner (1985). There is also evidence that there is a difference in resilience across countries. Cohen and Shin (2004) use an event study methodology to examine how markets from different countries respond to terrorism. They find that US markets recover sooner from terrorist attacks than any other global markets. Arina, Ciferri and Spagnolo examine how the stock returns and volatility of the markets of six specific countries (Indonesia, Israel, Spain, Thailand, Turkey and UK) respond to terrorist activity. They also conclude that terrorism statistically affects the returns and volatility of stock prices in all the examined countries; however the amount of response is different. They find that the wealthier nations from Europe (Spain and the UK) are less affected by terrorist activity. Kollias et al. (2011) examine how these two countries, Spain and the UK, were affected by two major terrorist attacks, the bombings of Madrid in 2004 and London in 2005. They follow an event study methodology to investigate the impact of the events on general and sector indices. They use two models to compute the normal return. First they calculate the normal return by using the constant mean return model secondly they use the market model as described by MacKinlay. Their findings show that the reactions on the actual day of the terrorist attacks are similar but that there is a significant difference in the recovery time needed for the markets to recover. The markets in London recovered in one single trading day while the markets in Spain needed a few more days to recover. Possible explanations for the difference in recovery time were argued to be caused by differences in size, structure and liquidity of the markets involved. However, it could also have been caused due to possibility of further attacks. The terrorists responsible for the Madrid bombings were not neutralized to a few pg. 5 days later, while the attacks in London were suicide bombers. The difference in recovery time needed might also be caused by the different reactions of the countries’ financial institutions. The Bank of England, HM Treasury and the Financial Services Authority had instigated contingency plans (created after 9/11) directly after the attacks so that the UK financial markets could keep trading. Both attacks increased market volatility significantly affecting both countries’ markets equally. Sector indices provide a varied conclusion with Spanish indices being affected the most however not consistently. Overall conclusion is that the affect of the terrorist attacks was fairly brief on the markets. Eldor and Melnick (2004) examine daily data to analyze the impact of Palestinian terror attacks on the stock and foreign exchange markets of Israel. Attacks occurred after September 27, 2000 had a permanent negative effect on the stock market but not on the foreign exchange market. The stock market decline suggests that the terrorist attacks have a damping effect on firms’ expected profit. The lack of response on the foreign exchange market means the value of the Israeli shekel was not influenced by the attacks. In the paper they distinguish differences in the types of terror attacks. They find that suicide bombing attacks have a permanent impact on the markets, other types do not. They find that attacks on transportation have a brief effect on the stock market; attacks on other targets do not have an effect.