Terror attacks and exchange rates : empirical evidence from developed and emerging countries

Abstract

Terrorism and terror attacks form a rising threat to the economy and financial markets, while the research area related to terrorism and foreign exchange markets still remain limited. Investigating terror attacks and exchange rates is essential due to the fundamental position of exchange rates in every international trade. In addition, exchange rates play an important part in pricing international financial instruments, such as derivatives. The aim of this thesis is to investigate the relationship between terrorism and exchange rates from three different viewpoints: geopolitical risk in terms of terrorism and its effect to uncovered interest rate parity (UIP) deviation, cumulative abnormal returns (CAR), and explanatory variables of CAR.

By investigating terror attacks, geopolitical risk indices, and a set of exchange rates with linear regression models and event study methodology, this thesis shows that terrorism can cause different effects among developed and emerging countries. In addition, the empirical results indicate that currency pairs from emerging countries are generally more affected by terror attacks causing statistically significant results. Furthermore, the results show that an increase in geopolitical risk leads to a significant increase in UIP deviation as well as local currency risk premiums among selected emerging countries.

This thesis obtains new evidence of how UIP deviation is affected by geopolitical tensions in terms of terrorism in emerging countries. Information can be valuable for investors and other market participants. In addition, the results highlight that also in the future terrorism will play an important part in geopolitical risks that should be considered when making financial decisions.