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Identifying Irrationality and Fear-Driven Reactions to Financial Market Shocks & Terrorism

By Kimberly M Roland

Abstract

Economic research on post 9-11 terrorism lacks a distinction between fear-based reactions and rational financial market behavior in its analysis surrounding terror strikes. The purpose of this paper is to expose and interpret the fear triggered by terrorism in financial markets, and to separate rational market responses from irrational, fear-driven investor reactions. A rational market response follows the efficient market theory (Wang 1993) in which investors alter their behavior based on changes in fundamental values. Becker and Rubinstein (2011) define terror-triggered fear as the magnitude with which subjective beliefs about danger hinder objective risk assessment. I apply this definition to the De Long et al (1990) discussion of noise trading to define irrational investor reactions as a response to subjective beliefs about danger and disregard for fundamental risk that causes volatility and a divergence from fundamental valuations. I observe the Volatility Index (VIX) and change in 10-year Treasury yield surrounding terror events to identify irrationality, and differentiate from rational market behavior through a comparison to the two gauges surrounding foreign and domestic central bank action. I analyze market behavior surrounding 9-11 and recent 2013 and 2015 terror events and find consistently heightened post-event volatility. I observe responses in the 10-year Treasury yield, and find that response duration is dependent on the implications for Federal Reserve policy and expectations of demand for safe-haven assets (Krishnamurthy & Vissing-Jorgensen 2012). I also find a decrease in magnitude of financial market response from 2001 to 2015, which could be due to prior experience with terrorism (Becker & Rubinstein 2011) or the Federal Reserve’s recent consideration of global instability in domestic monetary policy

Topics: Financial Risk, Volatility, Irrational Market Behavior, Terrorism, Behavioral Economics, Economic Theory, Finance
Publisher: OpenCommons@UConn
Year: 2016
OAI identifier: oai:opencommons.uconn.edu:srhonors_theses-1500

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