Stock Market Interdependence During Iraq War

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Investment Management and Financial Innovations, 3/2005

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Stock Market Interdependence during the Iraq War
Stefano Paleari, Renato Redondi, Silvio Vismara Abstract
This paper aims to show how consolidated and innovative methodologies can be employed to assess the financial impact of a global shock. Particularly, we consider the Iraq War in 2003 and its impact on the market indexes of five of the most capitalised stock markets in the world, U.S., U.K., France, Germany and Italy. After using an event study methodology to assess the direct impact of War events on the five selected markets, we extensively analyse the correlation between these markets. Since cross-market correlation coefficients are conditional on market volatility, tests for market interdependence based on these coefficients are inaccurate due to heteroskedasticity. Therefore, during crises when markets are more volatile, like during the Iraq War, estimates of correlation coefficients tend to increase and be biased upward. We correct for the bias as proposed by Forbes and Rigobon (2002) and estimate the time-varying correlation index using the Kalman filter methodology. Our research objective is to verify whether during the conflict the correlation among markets varied significantly. We find that correlation increases between Italy, U.K. and France whereas it decreases between these markets and both U.S. and Germany. We explain this behaviour building up a Country-specific exposure index considering jointly the direct involvement in the War and the economic linkages with Iraq, measured in terms of oil imports. JEL: G14, G15, G22. Key words: stock market interdependence, Event Analysis, Iraq War.

1. Introduction
On 12 September 2002 U.S. President George W. Bush warns world leaders gathered at a U.N. General Assembly session that the Iraq regime of Saddam Hussein poses “a grave and gathering danger” to peace, and urges world leaders to “move deliberately and decisively to hold Iraq to account”. In the same month, British Prime Minister Tony Blair publishes a dossier on Iraq’s military capability. A half-year later, on 20 March 2003, the Iraq War commences; Bush delivers a live television address shortly after explosions rocked Baghdad, signalling the start of the US-led campaign to depose Iraqi leader Saddam Hussein. During these six months, the international community is split. The U.S.A. and the U.K., on one side, take military action, and Germany and France on the others, call for a diplomatic solution to the crisis. Seldom in recent diplomatic history have the words of ally nations been so in contention on such a crucial issue. It is therefore important to investigate the stock markets reactions from belligerent and war-averse Countries to “War news”. To this extent, we examine through an event study methodology the effects of War’s key events on the market indexes of the U.S. and the European greatest economies (i.e. Germany, France, Britain, and Italy). We find that four events are significant on more than one market. The first event, U.S. President Statement addressing the United Nations warning of Iraqi threat (12 September 2003), shows a negative return on a one-day basis. A negative effect is registered even for Blix’ report on Iraq’s failing to disarm (27 January 2003). Then, U.S. ultimatum, and consequent joint French-Russian-German statement of disagreement, on 17 March 2003, causes a significantly positive index on an aggregate five-market level. At a single Country level, the French market reacts particularly well to this “news”. Finally, a positive return is related to the entry of the Coalition Forces in central Baghdad on 7 April 2003. The first and the last of these significant events, i.e. U.S. President Statement on 12 September 2002 and Coalition entry in central Baghdad on 7 April 2003, are then used to identify the turmoil period related to the War. During this period the mean index variance of the five markets is indeed...
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