Growing Pains: International Instability and Equity Market Returns

• DOI: http://doi.org/10.1111/fima.12165
• Date: 01 March 2017
• Author: Zhuqing Yang,Andrea Y. Lu,Zhuo Chen
• Published date: 01 March 2017

Growing Pains: International Instability

and Equity Market Returns

Zhuo Chen, Andrea Y. Lu, and Zhuqing Yang∗

We use the ratio of growth in global military expenditures to gross domestic product (GDP) to

capture ex ante expectations of political instability and explore the relationbetween this measure

and returns. In a standardglobal asset pricing framework with 44 countries, this measure helps to

explain cross-country return differences. Furthermore, emerging countries have greaterexposure

to international political instability risk than developed countries. This partially explains the

higher returns observed in emerging countries.

Stock market returns differ across countries and these differences are especially large between

emerging and developed countries. Many international asset pricing models have been proposed

to explain this cross-country variation including the world capital asset pricing model (CAPM)

(Cumby and Glen, 1990; Harvey,1991; Ferson and Harvey, 1993, 1994), the global exchangerate

risk model (Dumas and Solnik, 1995), and others. Meanwhile, global financial markets seem to

be connected via political events. When global/regional political eventsoccur, international stock

markets tend to respond accordingly. For example, when North Korea’s nuclear bomb testing

took place on May 25, 2009, not only did surrounding countries’ (e.g., Japan, South Korea) stock

markets fall, other markets also fell. Emerging markets seem to be more susceptible to political

events when compared to developed markets. To complement existing international asset pricing

models, we investigate this political tie and propose an instability risk measure that is associated

with the constantly evolving international political tensions and conflicts. We find that countries’

exposures to the instability risk are reflected in their stock market returns. In addition, these

differences in exposure also partially explain the return spread between developed and emerging

markets.

Rather than reviewing the impact of actual political events on financial markets, we recognize

that investors’ perceptions of risk can elevate prior to the occurrence of crises and such change

in perception could affect assets’ risk premia ex ante.1As argued by Jackson (2009), wars that

Wethank an anonymous referee,Marc Lipson (Editor), Snehal Banerjee, Geert Bekaert (discussant), Jules van Binsbergen,

Jonathan Brogaard, Jason Chen, Anna Cieslak, Zhi Da, Paul Gao, Ravi Jagannathan, Heikki Lehkonen (discussant),

Christian Lundblad (discussant), Dimitris Papanikolaou, Jonathan Parker, Christophe Spaenjers (discussant), Annette

Vissing-Jorgensen, Bohui Zhang (discussant), and seminar participants at the 3rd Luxembourg Asset Management

Summit, the 2014 China International Conference in Finance, the 24th Annual Conference on Financial Economics

and Accounting, the 2013 FMA Annual Conference, the Midwest Finance Association 2013 Annual Meeting, the 25th

AustralasianFinance and Banking PhD Forum and conference,and the Kellogg Finance Bag Lunchfor helpful comments.

This paper has benefited from the visitor program of the Centre for Asian Business and Economics at the Faculty of

Business and Economics of the University of Melbourne. The authors are responsiblefor any remaining errors.

∗Zhuo Chen is an Assistant Professor of Financeat the PBC School of Finance at Tsinghua University in Beijing, China.

Andrea Y.Lu is a Senior Lecturer of Finance at the University of Melbourne in Melbourne, Australia. Zhuqing Yangis a

PostdoctoralAssociate at the MIT Sloan School of Management in Cambridge, MA.

1Most studies in this area adopt a case study approach and focus primarily on the impact on the parties that are closely

involved in the event. Willard, Guinnane, and Rosen (1996) analyze events that took place during the US Civil War,

Bittlingmayer (1998) studies the movementof stock volatility in Germany during the transition from Imperial to Weimar

Financial Management •Spring 2017 •pages 59 – 87

60 Financial Management rSpring 2017

“did not happen” might have disturbed investors and affected macroeconomic performance. The

actual occurrence of wars may not be a good indicator of the presence of international instability.

A nuclear war never eventuates, but the arms race between the Soviet Union and the United

States during the Cold War greatly affected investors’ perceptions of risk. Thus, in this paper, we

emphasize the political instability risk associated with constantly evolving political tensions and

conflicts, and investigate how such risk affects international asset prices.

We propose a measure for international instability risk by taking insight from the burgeoning

research on strategic militarization and international conflicts. Military expansion, which often

serves as an early indication of the threat of war, has been constantly shaping the outcomes

of international interaction, as well as countries’ political and economic policies. As argued

by Jackson and Morelli (2011), wars are costly and risky, so rational states have incentives to

negotiate a settlement that is preferred to the gamble of war. Militarization is often used to

signal the governments’ inclination toward war or different understandings of the underlying

state of the world (Chassang and Miquel, 2010). In addition, militarization changes the final

payoff of a hypotheticalwar and serves as a commitment mechanism that makes the threat of war

credible (Fearon, 1997). For either reason, countries find ways to mold international bargaining

in peacetime through strategic militarization.

We capture international instability risk using the growth of global total military expenditures

as a percentage of total gross domestic product (GDP). This proxy captures the simple idea that

any increase in military expenditures could potentially lead to an increase in the probability of a

crisis and/or an increased destructiveness should a crisis does occur. Thus, an escalation in global

militarization may cause uneasiness in the stock market and rational investors could factor in this

impact when they make investment decisions. To the best of our knowledge, our paper is the first

to study the implications of countries’ militarization on asset prices.

Our empirical results support our hypothesis. First, using 44 country stock indices, we find

that international instability risk (IIR), proxied by the growth of global militarization, is a valid

systematic risk factor in international stock markets. The cross-country pricing power of inter-

national instability risk survives after controlling for other pricing factors including the world

market return, the exchange rate factor, global production shocks, and global fiscal policy shocks.

In addition, we find that higher returns observed in emerging countries are associated with greater

exposure to international instability risk. Moreover, we find that international instability risk is

more likely to affect international stock markets through the consumption channel, but less likely

through the actual occurrence of wars. Meanwhile, countries’ exposure to international instabil-

ity risk is related with their local political stability. Our results are robust to other alternative

specifications of IIR or excluding financial crisis periods. Finally, consistent with the US stock

market’s low exposure to international instability risk, we find little evidence that international

instability risk affects the cross-section of returns in the United States.

Our findings are consistent with the theoretical predictions of the time-varying rare disaster risk

(Rietz, 1988; Barro, 2006). Our paper also complements previous empirical findings (Gabaix,

2012; Gourio, 2012; Wachter, 2013), who demonstrate that changes in the probability of rare

Germany, Frey and Kucher (2000, 2001) investigate the impact of events surrounding the World War II on European

participating countries’ government bond prices, and Zussman, Zussman, and Nielsen (2008) examine the financial

market’sreaction in both Israel and the Palestinian Authority to the outbreak of the Intifada in 2000. In addition, Leigh,

Wolfers, and Zitzewitz (2003) study the impact of the war with Iraq on US equities. All of these studies present an

important notion that the occurrence of crises has a significant impact on the f inancial markets. Some of the other

literature use elections to identify shocks to a country’spolitical risk and study its relation with corporate investment and

stock abnormal returns including Durnev (2010), Julio and Yook (2012), Pantzalis, Stangeland, and Turtle (2000), and

Gao and Qi (2013).