Bridge over ocean
1 April 2016 CFA Institute Journal Review

Terrorism and Its Impact on the Cost of Debt (Digest Summary)

  1. Marc L. Ross, CFA

Extending the research on the costs of terrorism, the authors consider the long-term impact of terrorist activity on capital markets and find that countries affected by terrorism experience a higher cost of debt.

What’s Inside?

The authors evaluate the effects of terrorism on bond prices in developed and developing countries and use sovereign credit risk as a proxy for debt costs. Terrorism can result in a higher cost of debt for the governments of affected countries as well as for companies located in those countries. By extension, such heightened risk may result in lower bond ratings for the sovereign.

How Is This Research Useful to Practitioners?

The risks associated with terrorism will remain a salient issue for the foreseeable future. In addition to the direct cost that it exerts through loss of life and damage to property and infrastructure, terrorism imposes longer-term indirect costs in the form of reduced demand for goods and services, supply chain interruptions, increased cost of doing business because of the need for insurance, and decreased foreign direct investment as a result of capital flight.

Previous research explored the indirect economic costs of terrorism and focused on certain macroeconomic indicators, the shorter-term impact on the stock market, and the longer-term impact on capital markets. The authors examine the third category, which has received scant attention. In particular, they explore recent research that found a small group of countries in the Middle East and North Africa experienced heightened sovereign risk from 2002 to 2006 because of terrorism, resulting in higher sovereign bond yields in the Eurobond market.

The authors not only expand on the effects of terrorism on capital markets but also demonstrate its impact on macroeconomic activity and equity market behavior. Their results will help inform investors’ portfolio construction and risk management.

Examining the influence of terrorism on more than 100 countries’ sovereign credit risk ratings reveals a significant reduction in a developed country’s credit rating in response to an increase in terrorism. Developing countries experience a similar but even more pronounced reduction. The authors’ model also has predictive power in an out-of-sample test.

Portfolio managers and risk officers will gain valuable insights from this article, enabling them to make better-informed investment decisions through more prudent risk management and asset allocation.

How Did the Authors Conduct This Research?

Although terrorism is an extensively studied topic, the analysis of its macroeconomic effects and its costs to financial markets is less developed. The authors endeavor to broaden the existing literature.

They develop a regression model to test their hypotheses that terrorism is negatively correlated with the cost of debt, as reflected in sovereign credit risk ratings, and that the effect of terrorism is more intense in developing than developed countries. Standard & Poor’s sovereign credit ratings from 2002 to 2011 serve as a proxy for sovereigns’ debt costs. The Institute for Economics and Peace Global Terrorism Index measures terrorism’s social and economic impact, scoring countries on indicators of total number of incidents, fatalities, and injuries as well as amount of property damage. The index also accounts for terrorism’s lingering effects by weighing prior years’ scores in descending order. It is the most comprehensive database on incidents of global terrorism, examining 158 countries over the past 10 years.

The authors use variables to control for factors that can affect sovereign risk ratings, such as solvency, stability, social cohesion, and degree of interdependence with global economic and financial systems. They divide the factors into two categories: economic (e.g., GDP, inflation, and exports) and governmental (e.g., corruption control and political stability). Countries are classified as developed or developing economies based on the International Monetary Fund’s 2012 World Economic Outlook. Compared with developing countries, developed countries’ credit rating, on average, is higher and the incidence of terrorism is lower.

Using country-level data from 2002 to 2011, the authors use a regression model that solves for a country’s sovereign credit rating as a function of its terrorism risk and economic control variables. Analysis supports the authors’ hypotheses. Terrorism has a statistically and economically significant impact in countries where it occurs, resulting in a higher cost of debt for the sovereigns and for the firms in those countries. The effects are greater in developing than developed markets. Numerous robustness checks to ensure that the results are not subject to reverse causality, omitted variable bias, and incorrect regression methodology support the authors’ findings and conclusions. Finally, an out-of-sample test for the 2012–13 period produces outcomes substantially similar to those in the in-sample results, confirming the model’s predictive power and usefulness for hedging against or speculating on terrorist activity as well as for constructing more efficient portfolios.

Abstractor’s Viewpoint

Terrorism continues to be a relevant geopolitical consideration. How and to what degree it affects countries’ credit risk would be a useful tool for the portfolio and risk management processes. It is worth noting that the results are for a relatively short time frame for both the in- and out-of-sample outcomes because the Global Terrorism Index, a critical input to the model, is quite new. Additionally, the use of sovereign credit ratings as the proxy for cost of debt is less complete and direct than actual sovereign bond yields. Further research could extend the methodology to both emerging and frontier markets to better understand terrorism’s effects as well as to investigate its possible impact on other financial instruments and economic sectors.

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