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79Investing in war: Empirical Evidence of Investors' unsustainable Behavior in Times of Armed Conflict*
Esmira SAFAROVA
Mondeliz International, Inc [email protected]
Abstract. We investigate the impact of the armed conflicts, economic sanctions, and other threats on the equity risk premium estimated dynamically using generalized autoregressive conditional heteroskedasticity (GARCH) approach. We find that the ERP fall to negative values during period of conflict. The results could be explained by unethical behavior, selfish motivation and "myopic risk-seeking" of equity investors. This behavior is robust across all countries, periods and selected national stock indices covered in research.
Аннотация. В работе исследуется влияние вооруженных конфликтов, экономических санкций и других угроз на премию за риск для обыкновенных акций, моделируемую динамически как GARCH-процесс. ERP падает до отрицательных значений в период конфликта. Результаты можно объяснить неэтичным поведением, эгоистичной мотивацией и близоруким восприятием риска инвесторами. Феномен устойчив по странам, срокам и национальным фондовым индексам, охваченным в исследовании.
Key words: War, economics of armed conflict, sustainability, market behavior, risk premium, GARCH.
ESTIMATION OF RISK PREMIuM uSING ARCH/GARCH MODELS
There are three main approaches that are used to estimate the ERP. The first is to survey subsets of investors and managers, financial directors, academics in order to obtain information about their expert expectations about returns on equity in the future (survey-based ERP). The second, historical premium approach, is to analyze the returns obtained in the past on equities relative to risk-free investments and use this historical equity premium as the expectation. The third approach is to attempt to analyze a forward-looking equity premium based on the current trading prices or some market rates; it is also called implied premiums approach.
ARCH (AutoRegressive Conditional Heteroscedas-ticity) is well-known econometric model used for the analysis of time series (especially financial). Based on ARCH, the conditional variance is equal to:1
1 Determinants of the time varying risk premia, Pornpinun Chan-tapacdepong University of Bristol March 13, 2007, Department of Economics, University of Bristol
a] = V(ut | ut_i_.jut_p) = a0 + ^£aiuf_i,
i=1
where a is basic volatility; ut — time series.
ARCH models were first proposed by Engle in 1982. Already in 19862, Bollerslev proposed a generalization of these models (GARCH). ARCH-model assumes the dependence of the conditional variance only on the squares of past values of the series. One can generalize this model by assuming that the conditional variance also depends on past values of the conditional variance:3
q p
ot = a0 + £pya?- j.
¡=i j=i
GARCH-in-mean (GARCH-M) was proposed by Engle et al. in 1987. In this case, it is not a special model for the conditional variance. It is about using
2 Engle, R. F., Lilien, D. M., and Robins, R. P., 1987, Estimating Time-Varying Risk Premia in the Term Structure: the ARCH-M model, Econometrica, Vol. 55, No 2 (March 1987), p.391-407.
3 Determinants of the time varying risk premia, Pornpinun Chan-
tapacdepong University of Bristol, March 13, 2007, Department of
Economics, University of Bristol
* Инвестиции в войну: эмпирический анализ поведения инвесторов в периоды вооруженных конфликтов.
the conditional variance as a factor of the regression model for the risk premium. If we denote the excess return yt, then the GARCH-M model means that:4
y = a + f (a?) - E [f (a?)] + ut.
Returning to GARCH, it combines mean and variance processes estimations and establishes risk-return connection at market level.
In practice scholars failed to confirm steady relationship. The probable cause of it is the evolution of market processes. Returns were supposed to be driven only by their mean and variance until Ball and Torous (1983) refuted the thoughts of continuous sample path of stocks by presenting the evidence that stocks have log normally distributed jumps. The GARCH model is able to capture smooth returns fluctuations and variation while it fails to predict occasional significant movements. Taking these "jumps" into consideration allows to model risk properly. It implies that jumps are the third variable which along with mean and variance explains stock returns. The introduction of jumps allows for non-normality of returns' distribution which has been observed during the recent financial crisis.
Chan and Maheu (2002) introduced the autoregressive jump intensity model (ARJI) which is the extension of the jump diffusion model. Their novelty is the integration of GARCH model into the jump diffusion model. This combination yields the capture of both the smooth and persistent volatility changes over time and sudden jumps of returns together with clustering of these jumps and time-variation of its size. Returns are modeled in accordance with the simple diffusion model and the Poisson jump model of stock returns for the additional source of volatility. The number of jumps per period is defined by the Poisson process.
The paper of Arshanapalli, Fabozzi, and Nelson (2011)5 proposes an approach that combines GARCH-M model with the autoregressive jump intensity (ARJI) model in order to test the equity risk-return relationship. The dataset consists of monthly market risk premiums which are calculated as the difference between the value-weighted returns on NYSE, AMEX, and NASDAQ stocks and one-month T-Bill rate for the period of 1926-2010. The findings support the significance of strong risk-return relationship after 1950. The expected returns are greatly affected by jumps when they occur through the conditional
4 Ibid.
5 Arshanapalli, B., Fabozzi, F. J., and Nelson, W., 2011, Modeling the Time-Varying Risk Premium Using a Mixed GARCH and Jump Diffusion Model, Working paper series, SSRN No 1893038.
variance. The jump size depends on the sign of the equity premium for the previous period: if it is negative the size will increase, if it is positive the size will decrease.
Following the main purpose of the study Arshanapalli et al. find the empirical evidence of existence of persistent relationship between risk and return and suggest that the jump should be considered as element of risk and taken into account by investors.
This model requires determination of the risk-free rate, which is rather difficult for developing countries. The choice of Arshanapalli et al. to take U.S. one-month T-Bill rate as risk-free is stipulated by monthly data. Developing countries hardly have liquid or issue one-month debt securities. Also the complexity of the approach makes it difficult to apply in day-to-day practice. Moreover it doesn't assume of modeling the term structure of equity premium.
ARMED CONFLICTS AND WAR: CONCEPT AND CONSEQUENCES
According to the Nobel Laureate Richard E. Smalley war is among the ten biggest problems facing the society of mankind for the next fifty years, it takes the 6th place6 in his rating. In the 1832, the military general of the Prussian army Carl von Clausewitz in his treatise On War defined the war as follows: "War is ... an act of force to compel our enemy to do our will."7
Leading research centers headed by Uppsala University (Sweden) and the Center for International Development and Conflict Management (CIDCM) at the University of Maryland (USA) define armed conflict as contradiction concerning the power or territory, that is disputed by the application of armed force by the political communities of at least two opposing sides, and in which at least 25 people die8. If the confrontation involves government armed forces, it is considered to be a "state-based conflict". If the state is neither one of the warring parties, the conflict is considered to be "non-state". The "war" can be considered only as a relatively large and intense conflict — the armed confrontation, which directly led to the deaths of at least 1,000 people per year (direct combatants and civilians killed as a result of military action).
Main cause of wars is the desire of the political
6 Smalley, Richard E. (2008). Smalley Institute Grand Challenges. Rice University. Retrieved 24 April 2011.
7 Clausewitz, Carl von (1984) [1832]. In Howard, Michael; Paret, Peter. On War [Vom Krieg] (Indexed ed.). New Jersey: Princeton University Press. p. 75.
8 Uppasala University, Department of Peace and Conflict Research, definitions on www.pcr.uu.se/research/ucdp/definitions/
Extrasystemic ■ Interstate □ Internationalized intrastate ■ Intrastate
Fig. 1. Number of armed conflicts by type, 1946-2010.
forces to use armed struggle to achieve a variety of foreign and domestic political purposes. Main means of achieving the objectives of war is an organized armed struggle, as well as economic, diplomatic, ideological, informational and other means of struggle. In this sense, the war is an organized armed violence, the aim of which is to achieve political goals.
The direct object of war is to impose one's will on the enemy. One political entity is trying to change the behavior of another, to make him give up its freedom, ideology, rights to something, to give away the required national wealth, the territory, water area, etc. Implementation of these aspirations by non-military means, for example, in the process of negotiations, accompanied by the threat of force, may lead to so-called "voluntary accession" of one state to another, without the use of armed force.
According to Linebarger, the war is a kind of conviction, expensive, dangerous, bloody and unpleasant, but very effective, if other measures do not provide the desired results9. Often the initiators of the war pursue indirect goals, such as strengthening of their internal political position, destabilization of the region as a whole, diversion of enemy's forces.
In real life there is often no clear distinction between the attacking and the defending sides, because both sides are on the verge of open aggression, and which of them will attack first is a matter of luck and adopted tactics.
For 2010, since the end of World War II 246 armed conflicts in 151 countries were registered. General statistics from 1946 to 2010 can be seen in Figure 110.
9 Paul M.A. Linebarger. Psychological Warfare. International Propaganda and Communications. ISBN 0-405-04755-X (1948). Revised second edition, Duell, Sloan and Pearce (1954).
10 Themner L., Wallensteen P., 2011, Armed conflict, 1946-2010, J PEACE RES 48 (4):525-536, Uppsala Conflict Data Program, De-
It should be noted that since the end of 2010 to the end of 2012 there was a sharp increase in the number of armed conflicts, especially civil wars. At the same time wars are often waged without heavy involvement of aggressor's human resources. Social networks, mass media and funded opposition are becoming the main instruments of war.
The growth of armed activity and the apparent desire of some states to contribute to conflict forced to think about the objectives of these states, what they want to achieve by means of direct or indirect entry into the armed conflict.
Armed conflicts and wars are the factors that have greatest and usually negative impact on the economy. Besides the fact that war is inherently extremely costly, the country may lose its key industries, which are the main source of replenishment of the budget. Thus, both sides of the conflict face the losses, financial and of course human.
This study is based on the desire to understand what motivates countries to join the armed conflict or inflame it. In other words, what is the potential profit from participation in hostilities?
A country can join the armed conflict of geopolitical or economic reasons. Geopolitical reasons may be associated with desire to gain control over the territory of the country, change the unwanted political regime, etc.
Economic reasons are most often associated with natural resources. For example, the cause of the war may be a desire to cancel the current contracts for extraction of energy resources with a subsequent transfer to the energy corporations of the aggressor or their allies. Also, armed conflicts may be initiated for other reasons: national, ethnic, religious, ideological, etc.
partment of Peace and Conflict Research, Sweden.
Within this broad topic of research, this paper analyzes the changes in equity risk premium in the countries involved in the armed conflicts and the war. And in this case conflicts are considered in conjunction with economic sanctions and threats.
DATABASE AND TOOLS USED
The Correlates of War Project (COW) was founded in 1963 by J. David Singer from University of Michigan (USA) with the main goal of systematic accumulation of scientific knowledge and information about the armed conflicts and war. All COW data is available free for public.
For the analysis it is necessary to choose those armed conflicts, where the participants had their national stock index. That's why we choose the second half of 20-th century and early 21-st century. We excluded participants, which hadn't developed stock market at the moment of involvement in the conflict. The third criterion is the period of conflict. It may be too short and also too long.
In case of short wars or conflicts, it is hard enough to measure the dynamics of stock indexes; often short wars and conflicts are part of a long full-scale confrontation. Thus the results can be distorted, and therefore data cannot be used in the study. As an example, there are numerous military operations between Israel and Palestine. To consider each conflict separately does not make sense, because in reality the conflict between these two countries is not terminated at the time of the ceasefire.
On the other hand, long-term wars are not always suitable for the analysis of the equity risk premium, as this indicator is influenced by many factors and the war is just one of them. For example, the second Chechen war, in which Russia participated, lasted about 10 years (1999-2009), a period of rapid growth of the Russian economy, and the country's participation in the conflict was not so significant, in order to really have a strong impact on stock performance. Therefore, changes in the equity risk premium in this period are unlikely to depend on the participation of Russia in the second Chechen war.
The last stage of preparation of the base is selection of equity indexes.
We analyzed 12 countries, including Australia, Canada, France, Germany, India, Italy, Netherlands, Pakistan, Peru, Turkey, United Kingdom and USA which were involved in eleven conflicts: Cenepa Valley; Communist Coalition; Gulf War; Invasion of Afghanistan; Invasion of Iraq; Kargil War; Libyan civil
war; Second Laotian, Phase 2; Vietnam War, Phase 2; and War in Kosovo.
For the analysis of the available database we used R-Project11 and historical prices of national stock indices from Bloomberg.12
The next step was to obtain the results of the equity risk premium. In our case, we do not need to obtain specific daily performance of the risk premium. We need to analyze the changes in ERP before the conflict (1 year), during and after conflict (1 year). This data was obtained with help of R-Project function and rugarch and quantmod libraries.
EMPIRICAL FINDINGS
In the course of the study we obtained very unusual and even unpredictable results. Almost always, regardless of the country, period and selected national stock index, the equity risk premiums reduced during involvement in armed conflicts.
Equity risk premium is the compensation to the investor for adoption of additional risk. Thus, the higher the risk, the higher the premium for it.
If the equity risk premium of the asset is reduced, this means investors perceive less risk associated with the purchase of an asset and, therefore, two things happen. First, investors who own this asset have benefit from the one-time capital gain, because future corporate profits now are discounted at a lower rate. This is similar to the effect of lower interest rates on the price of bonds. Second, assumptions about future revenues are changing. Since the size of the risk premium reflects the expected return, the decline in risk premiums means lower future returns.
If the equity risk premium for this asset class is rising as investors perceive more risk associated with their possession, things come back. The first consequence of the growth of risk premiums will the falling of the prices, because the future profits now are discounted at a higher rate. But, at the same time, investors can expect higher returns on their investments. Thus, in practice, the exact opposite happens to the fact that investors expect when they extrapolate future results of previous periods.
The very fact that during the conflicts investors perceive less risk is against to elementary logic, because armed conflicts in essence can be destructive to the economy.
Possible cause of this trend may be related to the hypothesis that the war is a business, a way of making a profit.
11 www.r-project.org.
12 www.bloomberg.com.
Fig.2. Dynamics of the S&P500 index during Gulf war.
Mar Apr May Jun Jul Aug
Fig. 3. Dynamics of the S&P500 index during the war in Kosovo.
Apr May J Lin Jul Aug Sep
Fig.4. Dynamics of the S&P500 index during invasion in Iraq.
It should be noted that most countries in our database of conflicts acted as aggressors, the wars were not carried out on their territory, and the main goal of the conflict was the resources of the country and political influence in the region. War as a whole was carried out against potentially
weak states, and hence the positive outcome was expected.
First analyst comments after the first strikes on Afghanistan by U.S. and British armed forces, stated that the military campaign launched by the United States against Afghanistan could benefit the U.S.
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economy in recession. At the same time, U.S. analysts cited the example of the Gulf War. For example, The Wall Street Journal expected an increase of interest in the stocks of the arms industry. Since the September 11 attacks the investors have been expecting retaliation from U.S., therefore the stock quotes of defense contractors steadily raised. Analysts noted that prior to the "sting operation" interest of investors was towards the shares of producers of electronic equipment for military purposes, and after it started, the demand for the shares of all arms producers increased.
In addition to government orders armed conflict is an additional justification to cover government debt through emission. Partly this can be done through the mechanisms of freezing the assets of the country, i.e. imposing sanctions. For example, in accordance with paragraphs 17, 19, 20 and 21 of UN Security Council Resolution 1970 (2011) and paragraphs 19, 20 and 21 of UN Security Council Resolution 1973 (2011), the U.S. authorities have frozen the assets of Muam-mar Gaddafi and members of his family worth about
$ 30 billion. The fall in the risk premium should occur simultaneously with the growth of the national stock indices. The growth of the stock indexes indicates positive expectations of investors regarding the available assets. Positive expectations, in turn, lead to reduction of the level of risk and the level of equity risk premiums respectively. Figures 2, 3 and 4 show the dynamics of S&P500 during Gulf war, war in Kosovo and invasion in Iraq.
According to the data, the period of U.S. entry into armed conflict is characterized by an increase in national stock exchange. The situation is similar in other countries.
Figure 5 shows the dynamics of the German index DAX 30 during the war in Kosovo.
The next index is French CAC 40. Figure 6 shows the dynamics of CAC 40 during the Gulf war.
The obtained results do not contradict the results obtained on the risk premium. Stock indexes during periods of conflict are really growing. It is worth noting that before the war, there is a short-term drop in the market, but most of the future growth is ahead of
Oct 5, 2010 : ™~FT5E 5,635.7993 """^GDAM 6,215,S3 "^FCHI 3,731.92
Fig 7. Dynamics of the European stock market during the conflict in Libya (2011).
Nov 2, 2010: ™~DJI 11,188,7197 — "IXIC 2,533.52 ™"GSPC 1,193.56
2010 Dec 1 Dec 30 2011 Mar 1 Apr 1 May 2 Jun 1 Jul 1 Aug 1 Sep 1 Oct 3 Nov 1 Dec 1
Fig. 8. Dynamics of the American stock market during the conflict in Libya (2011).
the previous period and this growth continues even after the official end of the armed conflict.
Speaking about the possible inaccuracy of data, it should be taken into account that the equity risk premium falls regardless of country or index type. The selected period also does not affect the result.
The only example of a departure from established patterns is the armed conflict in Libya in 2011. In this case, the risk premiums in France and the United States have increased at the time of their entry into the active phase of hostilities. However, this may due to the deep economic and political problems within countries: the public disapproval of austerity measures, the debt crisis in the U.S., the Eurozone crisis and political scandal surrounding the election campaign of the former French president Nicolas Sarkozy. All these facts could have an impact on the dynamics of the risk premium. The dynamics of the European and American stock market is described in Figures 7 and 8.
Summarizing, we can state the hypothesis that in the past few decades, the equity risk premium has fallen in response to the country's entrance into armed conflict. This contributes to the growth of the national stock indices and the expectations of a successful outcome of the war for the country.
CONCLuSION AND INTRODuCTION TO FuTuRE STuDIES
In the course of this study we have found very unusual results. Almost always, regardless of the country, period and chosen national stock index, the equity risk premiums have reduced in the period of involvement in armed conflicts. In such cases it is necessary to pay extra attention to double-check results and to study the problem in depth.
It is possible to highlight the following points for improvement of this research:
• selection of different methods of calculating the equity risk premium;
• use of different time periods;
• more in-depth analysis of the economic situation in the country during the conflict;
• grouping of conflicts and countries by categories;
• analysis of changes in the income in particular economic sectors
• social consequences.
Despite the fact that in the current study only minor deviations from the general hypothesis were identified, changing the method of calculation of the equity risk premium parameter may show slightly different results.
Short and excessively long conflicts were excluded in our research. For a more in-depth study it might be worthwhile to analyze how the market behaves in situations of short or long conflicts. Much also depends on the type of conflict and its intensity. It would be interesting to see how various forms of conflict, or conflict intensity, or sanctions affect the asset pricing. The role of countries is also worth mentioning in research, as they also can be divided into aggressors, defenders, the winners and losers, developed economies and undeveloped ones. Thus it is possible to obtain more specific information about the pricing of assets.
Various sectors of the economy in different ways may experience periods of conflict or crisis. For defense industries, manufacturers of military equipment and weapons, or information technology used for military purposes, war is profitable, because businesses get government contracts, the demand for their products increases, profits grow. However, there are other sectors of the economy — light industry, health, education, insurance, etc — which may experience an armed conflict differently.
Economics is inextricably linked to the social sphere, and conflicts affect human expectations and attitudes, unemployment, living standard and demographics. Therefore, the social aspect also needs analysis. And it is especially important to pay attention to social consequences of military conflicts and wars in those countries for which such conflicts were the most destructive.
Particular attention should be given to the analysis of the economies of countries which participated in the military conflicts, because conflicts are not the only factor influencing the equity risk premium. In assessing the economy one can analyze which phase (cycle) is the economy in, and identify cyclical pattern between the economy and the consequences of the armed conflict.
Recently, many researchers have been involved in the analysis of the issue of armed conflicts. It is one of the most popular topics of research and this is connected primarily with the scale of the possible consequences for the country and for humanity as a whole. However, in previous years the study of the issue has not been given special attention, because there are many aspects to the study of armed conflict, and many issues are still open.
Our result was confirmed by the positive dynamics of the national stock indices during the country's entry into the conflict. The growth of the stock indexes indicates positive expectations of investors regarding the available assets. Positive expectations, in turn, results in reduction of the level of risk and the level of equity risk premiums respectively. If the eq-
uity risk premium of the asset is reduced, this means that investors perceive less risk associated with the purchase of an asset, which is not typical for the period of war.
These results raise the question about what kind of benefit country can get from participation in the armed conflicts and war. Thus, results confirm the need for further, more thorough and in-depth study of the topic.
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