Geopolitical Risk and Trading Patterns of Foreign and Domestic Investors: Evidence from Korea

• Author: Oh Byung Kwon,Keun Jae Park,Young Sik Kim
• DOI: http://doi.org/10.1111/ajfs.12253
• Date: 01 April 2019
• Published date: 01 April 2019

Geopolitical Risk and Trading Patterns of

Foreign and Domestic Investors: Evidence

from Korea*

Young Sik Kim

School of Management, Kyung Hee University, Republic of Korea

Keun Jae Park

**

Department of Business and Economics, Washington and Jefferson College, United States

Oh Byung Kwon

School of Management, Kyung Hee University, Republic of Korea

Received 30 July 2018; Accepted 11 February 2019

Abstract

We examine how geopolitical risk affects investors’ investment strategies in the Korean mar-

ket. The information advantage hypothesis predicts that foreign investors become more reluc-

tant to invest in the portfolios of foreign countries due to increased information asymmetry

following geopolitical risk escalation while the international diversification hypothesis predicts

that foreign investors will not reduce the size of their foreign portfolios because their wealth

portfolios are sufficiently diversified. Using a novel measure of geopolitical risk, we find evi-

dence consistent with the information advantage hypothesis: when North Korea risk is highly

escalated, foreign investors reduce while domestic investors increase the value of their Korean

portfolios, and domestic institutional investors significantly outperform foreign investors due

to increased information asymmetry.

Keywords Geopolitical risk; Information advantage; International diversification; North

Korea risk; Political uncertainty

JEL Classification: G10, G15, H56

*We would like to thank Kwangwoo Park and Bohui Zhang (editors) and anonymous refer-

ees for their helpful comments. This work was supported by the Ministry of Education of the

Republic of Korea and the National Research Foundation of Korea (NRF-

2017S1A3A2066740).

**Corresponding author: Department of Business and Economics, Washington and Jefferson

College, Washington, PA 15301, USA. Tel: +1-724-503-1001, Fax: +1-724-223-6053, email:

kpark@washjeff.edu.

Asia-Pacific Journal of Financial Studies (2019) 48, 269–298 doi:10.1111/ajfs.12253

©2019 Korean Securities Association 269

1. Introduction

With the integration of the international financial market and the overcoming of

obstacles to foreign investments over the past few decades, investors have become

more interested in diversifying their portfolios through foreign assets. Country-spe-

cific risks in foreign markets (e.g., changes in political regimes, government policies,

monetary policies, and geopolitical conflicts), however, have deterred investors from

holding well-diversified international portfolios. Among these many risks, geopoliti-

cal conflicts have received a great deal of attention from practitioners and scholars

due to the fact that recent terrorist attacks and regional military conflicts have

raised concerns of potential exploitation or loss of portfolio value. Little is known,

however, regarding the impact of such geopolitical conflicts on the trading strategies

of investors in emerging markets.

This study examines the effects of geopolitical risk on the investment strategies

of investors in the Korean equity market. The geopolitical risk of interest in our

study is the interstate tensions on the Korean peninsula resulting from North Kor-

ean military actions. We argue that North Korean military actions are external and

exogenous shocks to Korean geopolitical risk escalation because these actions are

unpredictable from an investor standpoint due to the fact that North Korea is one

of the most politically and economically isolated countries in the world. It is impor-

tant to note that the subtle and inconsistent dynamics of Korean geopolitical facto rs

present a challenge when predicting potential paths of risk and their corresponding

outcomes. The magnitude of North Korea risk that investors perceive should thus

be quantified in multiple dimensions rather than simply considering military

actions in terms of homogenous levels of risk.

We construct a novel measure of geopolitical risk by collecting news reports

from the Korean media. We count the number of news reports related to North

Korea each day throughout our sample period and calculate ratios of these news

reports to the total number of news reports on that day. We believe that our

media-based measure is an effective proxy for the magnitude of North Korea risk

perceived by investors because they rely on news reports when gauging the serious-

ness of North Korea risk. Using this media-based measure, this study investigates

how foreign and domestic investors change their trading patterns for their Korean

portfolios in response to escalated North Korea risk.

Theoretically, two strands of research offer opposite predictions regarding trad-

ing pattern difference between foreign and domestic investors. The home bias litera-

ture posits that domestic investors have superior information regarding assets in

their home country compared to foreign investors (French and Poterba, 1991; Bren-

nan and Cao, 1997; Coval and Moskowitz, 1999; Kang and Stulz, 2000; Aggarwal

et al., 2005). Several studies theoretically and empirically show that under-diversifi-

cation of foreign investors’ decisions are actually optimal because they invest only

in assets for which they have comparative information advantages, and the resulting

concentrated investment strategies earn excess risk-adjusted returns (Van

Y. S. Kim et al.

270 ©2019 Korean Securities Association