Impact of terrorism and political instability on equity premium: Evidence from Pakistan

Impact of terrorism and political instability on equity premium: Evidence from Pakistan

Accepted Manuscript Impact of terrorism and political instability on equity premium: Evidence from Pakistan Wu MengYun, Muhammad Imran, Muhammad Zakar...

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Accepted Manuscript Impact of terrorism and political instability on equity premium: Evidence from Pakistan Wu MengYun, Muhammad Imran, Muhammad Zakaria, Zhang Linrong, Muhammad Umer Farooq, Shah Khalid Muhammad

PII: DOI: Reference:

S0378-4371(17)31162-7 https://doi.org/10.1016/j.physa.2017.11.095 PHYSA 18863

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Physica A

Received date : 17 July 2017 Revised date : 13 October 2017 Please cite this article as: W. MengYun, M. Imran, M. Zakaria, Z. Linrong, M.U. Farooq, S.K. Muhammad, Impact of terrorism and political instability on equity premium: Evidence from Pakistan, Physica A (2017), https://doi.org/10.1016/j.physa.2017.11.095 This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.

Impact of Terrorism and Political Instability on Equity Premium: Evidence from Pakistan Wu MengYun1 Muhammad Imran1,2* Muhammad Zakaria2 Zhang Linrong1 Muhammad Umer Farooq1 Shah Khalid Muhammad1 Abstract The study quantifies the impact of terrorism and political instability on firm equity premium in Pakistan using panel data for 306 non-financial firms for the period 2001 to 2014. Other variables included are law & order, government regime change and financial crisis of 2007/08. The estimated results reveal that terrorism has statistically significant negative impact on firm equity premium in Pakistan. This result is robust with alternative equation specifications. The result also remains same when terrorism variable is replaced with external and internal conflict variables. Law & order variable has significant positive effect on firm equity premium, which implies that equity premium increases with the improvement in law & order situation in the country. Equity premium also increases with government stability and when there is democratic system in the country. The result also reveals that global financial crisis of 2007/08 negatively influenced the firm equity premium. The study suggests some policy implications. Keywords: Equity Premium, Terrorism, Political Stability, Financial Crisis, Pakistan JEL Classifications: C23, G01, G12

1. Introduction Terrorism has become a global phenomenon because terrorism incidents have increased significantly over the last decade especially after 9/11 event. Terrorism has become a great safety threat to the world because terrorism has spread globally as terrorists have attacked almost all part of the world. The terrorist events create panic, fear, uncertainty, vulnerability and insecurity in the environment (Keeney and Winterfeldt 2010, Aslam and Kang 2015). Terrorism adversely affects politics, economic conditions and foreign affairs of a country (Atran, 2004). Several studies have examined the effect of terrorism on economic performance of the country and have shown that terrorism adversely affects the macro                                                              1

School of Finance and Economics, Jiangsu University, Zhenjiang, 212013, People's Republic of China, Department of Management Sciences, COMSATS Institute of Information Technology, Islamabad, Pakistan. * Corresponding Email: [email protected] 2

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economy of a country (Abadie and Gardeazabal 2003, Abadie and Gardeazabal 2008, Eckstein and Tsiddon 2004, Blomberg et al. 2004, Nitsch and Schumacher 2004, Gaibulloev and Sandler 2009, Buesa et al. 2007). Terrorism negatively affects the economy of a country by damaging human and physical capital and infrastructure, increasing counter-terrorism costs, increasing financial instability and by decreasing investors’ confidence (Johnston and Nedelescu 2006). Terrorism decreases foreign investment and trade by increasing business risk (Jain and Grosse, 2009). Terrorism increases the uncertainty which reduces the expected return on investment and investors feel reluctant in trading and flee to safe markets. It adversely affects the performance of financial markets (Eldor and Melnick 2004). Well-developed financial markets are important for economic development. Therefore, it is important to explore the determinants of stock markets. The effect of several variables like economic, social, political, demographic and environmental events on performance of stock markets has been discussed widely in literature. Examining the impact of terrorism on performance of financial markets have become important especially after the 9/11 event. There is abundance of literature which has examined the impact of terrorism on stock markets. The studies have shown that terrorism decreases the stock market returns and increases their volatility (Aslam and Kang 2015, Kollias et al. 2011, Drakos 2010, Eldor and Melnick 2004, Essaddam and Karagianis 2014, Barros et al. 2009, Nguyen and Enomoto 2009, Arin et al. 2008, Nikkinen et al. 2008).3 Empirical literature has explored the effect of terrorism on stock markets mainly of developed countries (US, Europe, Israel, etc.). Ahmad et al., (2016) concluded that terrorism has positive relationship on stock returns. However, in their study they use the terrorism a non economic variable with economic, company specific variables. In this current study, we are using the terrorism with other related non economic variable to see the its impact on firm level equity premium. Overall, only few studies have been conducted to examine the effect of terrorism on stock markets of emerging and developing countries. Moreover, the existing literature has examined the effect of terrorism on stock markets returns and volatility and has shown that terrorism decreases stock market returns and increases volatility. However, these studies have ignored the effect of terrorism on firm equity premium. According to Welch (2000, p. 501) equity premium is ‘perhaps the single most important number in financial economics’. Equity premium is an essential part in market portfolio allocation in different types of stocks, and calculation of cost of equity and cost of capital to select the best earning assets. Equity premium affects savings, spending                                                              3

Next section provides detailed literature review.

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manners and allocation of investors’ portfolios between risk free and risky assets. For valuation purpose, equity risk premium is an important factor of every risk and return model in economics and corporate finance (Damodaram, 2012). According to Damodaram (2008) equity premium is a central number that shareholders insist for investing in the stock market for having higher risk than money market investment. Given the important role which equity premium plays in stock market performance, determining equity premium has become important in recent years (Damodaram, 2016). Different factors like financial, political, economic, etc. affect equity premium. One important factor which affects equity premium in recent years is terrorism. Thus, examining the effect of terrorism on equity premium has become imperative. Stock market is also affected by risk related to instable and uncertain political conditions which are common in developing countries (Addoum and Kumar 2016, Campos et al. 2012, Goodell and Vahamaa 2013, Hartwell 2014, Smales 2014, 2015, Diamonte et al. 1996, Erb et al., 1996; Mei and Guo, 2004). A disturbed political system decreases economic growth of a country, which adversely affects the performance of its stock market. Unstable political condition decreases foreign investment in stock market as investors become reluctant to invest in a volatile political system which reduces their returns (Chan and John 1996). In turn, a stable political system is favourable for investors as it reduces risk and increases their rate of return. Diamonte et al. (1996) and Lehkonen and Heimonen (2015) have shown that reduction in political risk increases stock returns. After the event of 9/11, Pakistan is playing the role of frontline state against terrorism. As a result, terrorists started their terrorism activities in different parts of the country. This adversely affected different sectors of the economy including foreign investment, tourism, government spending on development projects, etc. It also adversely affected the stock market. Figure 1 provides the trend analysis of Pakistan stock exchange market (PSX) over the period 2001 to 2017. It is evident from the figure that stock market grew rapidly in 2000s. The KSE 100 index increased till 2007, which decreased in 2008 due to political instability and hike in suicide attacks in the country. However, in the wake of democratic government, stock market surged and the index crossed the value of 3000 in 2014. In June 2014 Pakistan army launched a military operation against terrorist in the country, which helped to improve the law & order situation in the country. As result stock market performance improved and the index reached to the value of 5000 in 2017. As of May 2017, there are 560 companies listed in PSX and the total market capitalisation is US$ 98 billion. PSX was reclassified as a Morgan Stanley Capital International (MSCI) Emerging Market in May 2017, while 3

the Finaancial Times Stock Exchange E ((FTSE) claassifies PSX X as a Seecondary Em merging Market. PSX is am mong the wo orld’s best pperforming stock s markeets.

Figure 1: Pakistan P Stock Exchaange Mark ket (PSX 100 Index, 20001 – 2016))

 

Sourcce: www.psx.coom.pk

Since PSX plays an im mportant rolle for the deevelopment of the counntry, it is im mperative to exam mine the efffect of terro orism on sttock markett in Pakistaan. Although gh few studiies have also beeen conducteed to investiigate the efffect of terro orism on sto ock market rreturn and volatility v (Aslam and Kang 2015, Aslam m et al. 20 14, Suleman 2012, Ah hmed and Faarooq 2008 8) but no study has been connducted so far f to examiine the effect of terroriism on firm m equity prem mium in Pakistann. This paper will conttribute to thhe existing empirical e litterature in m many folds.. First, it will invvestigate thee impact off terrorism aand law & order on firm equity ppremium in nstead of market returns andd volatility. Second, it will examin ne the impaact of terrorrism on firm m equity premium m in an em merging market, insteead of a deeveloped market. m Thirrd, this pap per will examine the effect of political stability on equity premium. Fourth, bessides terrorism and politicaal stability, the effectss of politiccal system (autocracy or democcracy) will also be examined on equity premium.. This variab able also hass important effects on sstock markeet which further translate too affect the equity riskk premium. Finally, th he effect off financial crises c of 2007/088 will also be examin ned using a dummy variable. v Th he outcomee of the stu udy will providee importantt policy im mplications to investors, investment bankks, compan nies and financiaal groups annd the goveernment reggulatory agencies who deal with the corporaations in Pakistann to minimiize the effeccts of such sshocks on financial fi maarkets.

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The rest of the paper is organized as follows. Section 2 explains the literature review. Section 3 discusses the model. Section 4 provides the estimated results along with its discussion. Final section concludes the paper.

2. Literature Review Empirically, several studies have been conducted to investigate the effects of terrorist events on stock market returns and volatility. For instance, Hobbs et al. (2016), Essaddam and Mnasri (2015), Aslam and Kang (2015), Essaddam and Karagianis (2014), Eldor et al. (2012), Drakos (2010), Karolyi and Martell (2010), Zussman and Zussman (2006) and Eldor and Melnick (2004) have found negative effect of terrorism on the stock market returns. Some other studies have examined the effect of terrorism both on financial market returns and volatility simultaneously. For example, Arin et al. (2008), Aslam et al. (2014), Barros et al. (2009), Nikkinen et al. (2008), Nguyen and Enomoto (2009), Bautista (2003) and Fernandez (2007) have shown that terrorism negatively affects stock market returns and make them volatile. Kollias et al. (2011), Nikkinen et al. (2008), Chaudhry (2005) and Berrebi and Klor (2010) have shown that terrorism has varying effects on different stock markets. Aslam et al. (2015) have suggested that the magnitude of terrorist attacks on stock markets varies with respect to country, severity of attack and attack type. Peleg et al. (2011), Eldor et al. (2012) and Aslam and Kang (2015) have concluded that more severe attacks have higher impact on stock markets. Coleman (2012), Christofis et al. (2013), Nikkinen et al. (2008), Chen and Siems (2004) and Peleg et al. (2011) have documented that financial markets are efficient, and absorb the impacts of such shocks very quickly. Apergis and Apergis (2016) have investigated the impact of terrorism on major companies of the defense industry worldwide and suggest that terrorism has positively affected the stock returns of companies of defense industry. Most of the research suggests that the effect of terrorism on financial markets is limited and lasts for a short period (Essaddam and Mnasri 2015, Chesney et al. 2011, Brounrn and Derwall 2010, Arin et al. 2008, Chen and Siems 2004). In turn, Eldor and Melnick (2004) have found that terrorist attacks have permanent effect on stock market (of Israel). Some studies have suggested that the effect of terrorism on stock markets is greater in emerging markets, and less in developed markets (Arin et al. 2008). Most of the studies have been conducted to examine the impact of terrorism incidents in developed countries, while

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the literature for emerging and developing countries is limited. Mnasri and Nechi (2016) investigate the effect of terrorism on stock market volatility in 12 MENA countries using event data methodology. The results indicate that the effect of terrorist incidents on stock markets last for up to 20 trading days, which is longer period compared to the impact of such incidents on the developed countries’ stock markets. Aloui and Nguyen (2014) evaluate the effect of major shocks on six selected stock markets in the Mediterranean countries (including Egypt, Tunisia and Turkey). The study reveals that major shocks, like 9/11 event, affect stock market returns. In Pakistan only few studies have been conducted to examine the effect of terrorism on stock market. Ahmed and Farooq (2008) have examined the impact of 9/11 event on stock market volatility in Pakistan. The study finds that the volatility behaviour of the stock market has changed significantly after 9/11 event. Using EGARCH model, Suleman (2012) has evaluated the impact of terrorist attack news on returns and volatility on Pakistani stock market. The study reveals that terrorism news increases the volatility of the market. Recently, using event study analysis, Aslam and Kang (2015) have shown that terrorism has negative impact on stock market returns in Pakistan. However, the effect is short-lived as the market recovers from terrorist shocks in one day. The study finds that the magnitude of this effect is positively related to the severity of the attack. Previously, Aslam et al. (2014) has also found the similar results by using EGARCH model. These empirical studies have examined the effect of terrorism on stock market returns and/or volatility. No empirical study has been conducted so far to explore the effect of terrorism on equity premium at firm level in Pakistan. This study will fill this gap. Empirics have shown that political uncertainty has negative effect on market returns and makes it more volatile (Diamonte et al. 1996, Aggarwal et al. 1999, Kim and Mei 1999, Laverde et al. 2009, Chau et al. 2014, Asteriou and Siriopoulos, 2000, Perotti and Oijen 2001, Boutchkova et al. 2012). Beaulieu et al. (2006), Bailey et al. (2005) and Frey and Waldenstrom (2004) have shown that political events have a strong impact on the returns and trading volume of the financial markets. Chan and Wei (1996) have shown that favourable political news produces positive returns and unfavourable news produces negative returns. Using data from 1993 to 2013 for 18 OECD countries, Asteriou and Sarantidis (2016) have revealed that there is negative relationship between political instability and stock market returns. For Pakistan, Arzu (2011) has shown that political instability has negative effect on stock market returns. Raza and Malik (2013) have shown that bad news have more effect on volatility of stock market return then good news in Pakistan. Nazir et al. (2014) have shown 6

that political events have only short run effect on stock market in Pakistan as stock market recovers in 15 days after the occurrence of political event. Again these studies have not examined the effect of political (in)stability on equity premium at firm level in Pakistan. This study will fill this gap.

3. The Model Equity risk premium can be modelled using different asset pricing models like capital asset pricing model, arbitrage pricing theory, three factor model and multifactor models. Markowitz (1952) was the first to provide the basis of the risk and return theory. Markowitz theory was further developed and constructed into Capital Asset Pricing Model (CAPM) by Tobin (1958), Sharpe (1964), Lintner (1965) and Mossin (1966). The CAPM was criticised for its single factor measure, which gave birth to Arbitrage Pricing Theory (Roll 1977, Ross 1976), followed by three factor model (Fama and French 1996, Carhart 1997) and multifactor model (Fama and French 2002). Similarly, relevant to the different degrees of risk, macrobased and micro-based risk factors models were also developed accordingly. However, there is still room to add new phenomena of non-economic factors to evaluate the association between equity premium and its possible determinants. In this study we will use an augmented version of Fama and French (2002) multifactor model to examine the effect of non-economic variables (i.e. Terrorism, law & order, political stability, government regime change and financial crises) on firm level equity premium in Pakistan. The augmented multifactor model is explained as follows:

Where





1



is equity premium of firm at time ,

political stability,



is terrorism,



is law & order,

is

is government regime change (autocracy or democracy) and

is

2007/08 global financial crisis dummy. Terrorism creates fear in the society and makes business environment risky and uncertain which adversely affect stock market. It will decrease the equity prices. Thus, the sign of the coefficient

is expected to be negative i.e.

0. In turn, a better law & order condition will improve the economic environment for porfolio investment, which will increase the equity prices. Thus, the theoretically expected sign of

is positive i.e.

0. Political instability adversely affects the stock market. The

intuition is that political instability engenders uncertainty in economic policies which 7

discourages investment as the risk of capital loss will increase with political instability. In uncertain political environment risk-averse economic agents may exit the economy and prefer to invest abroad. In turn, in political stable environment investment in financial market will increase, which will increase the demand for equity and hence equity premium will increase. Thus, the coefficient of political stability

0. Savun and

will take a positive sign i.e.

Phillips (2009) have shown that in democratic countries the stock market are more efficient and can translate the incidents into price change quickly. This means that democracy increases the market value of share in the capital market. Thus, i.e.

is expected to be positive

0 . According to Choi et al. (2010) global financial crisis provides a better

understanding of the risk in the equity market and investors need to consider the risk generated by the crisis itself. This study will also examine the effect of global financial crisis of 2007/08 on equity premium. The coefficient of the financial crisis variable to take negative sign i.e.

is expected

0.

4. Data, Results and Discussion 4.1. Variable Construction and Data Sources For empirical analysis annual data is collected for 306 non-financial firms listed at Pakistan Stock Exchange (PSX) for the period 2001 to 2014. These non-financial firms are selected on the basis of their liquidity and only those firms are selected which have been traded for at least eight month throughout a year. Both firm returns and risk free returns are calculated using the following formula:-



where

is rate of return,



2

is the price of an asset at time

1 and

is natural

logarithm. Following Fama and French (2002) we can calculate the equity premium by taking the difference of market return

and risk free return

i.e.

3 Data on firm stock prices and risk free rate of return is taken from Pakistan Stock Exchange (PSX), Economic Survey of Pakistan and International Finance Statistics (IFS). Terrorism is number of killings in terrorist activities and its data is taken from Global 8

Terrorism Database (GTB). Law & order is an index ranging from zero to six with zero the worst law & order situation. Government stability is an index ranging from zero to twelve with zero the most unstable government and twelve with the most stable government. Government stability has three sub-components i.e. government unity, legislative strength and popular support. Data for law & order and government stability is collected from International Country Risk Guide (ICRG). Government regime change (autocracy or democracy) is proxied by a dummy variable, which takes the value of 1 if country has democratic system and zero otherwise. To gauge the effect of 2007/08 global financial crisis on equity premium a dummy variable is included in the model which takes the value of 1 for the period of financial crisis 2007/08 and zero otherwise. For robustness analysis internal conflict and external conflict variables will also be used. Internal conflict has three subcomponents, which are civil war/coup threat, terrorism/political violence and civil disorder. The components of external conflict are war, cross-border conflict and foreign pressure. The scores of both internal and external conflicts fall between 0 (very high risk) and 12 (very low risk). The data for internal and external conflicts is taken from ICRG. 4.2. Summary Statistics Table 1 provides the summary statistics of the variables. It shows that equity premium has mean value of 0.05, which fluctuates between -3.86 to 5.39. Terrorism is a serious issue in Pakistan as the mean value of terrorism is quite large i.e. 1185.50 deaths per year and has a range of 105 to 2871 deaths. The value of standard deviation of terrorism is also very high (985.31), which indicates that this variable has a large variation. The mean value of law & order is 3.23 with a range of 3 to 3.50. The standard deviation of law & order is 0.24. Similarly, the mean value of government stability is 7.29 with a range of 5 to 9.83. The standard deviation of government stability is 1.92. This shows that government is stable in last few years in Pakistan. Mean value of the external conflict is 8.39, which indicates that external conflict situation is somewhat better but the mean value of internal conflict is low (6.06) which shows that internal conflict is a serious issue in Pakistan. Table 2 provides the correlation of equity premium with its determinants. It is evident from the table that equity premium is negatively correlated with terrorism and this correlation coefficient is statistically significant at 1 percent level of significance. In turn, equity premium is significantly positively correlated both with external conflict and internal conflict, which implies that when external and internal conflict situations improve equity premium increases. Equity premium is significantly positively correlated with law & order variable, which implies that 9

when law & order condition improves equity premium increases in the country. Similarly, equity premium is positively correlated with government stability. It indicates that when political stability increases in the country, equity premium will also increase. The significant positive value of correlation coefficient of government regime variable indicates that when there is democratic system in the country, equity premium increases. In turn, the negative value of the correlation coefficient of financial crisis states that equity premium decreases with financial crisis of 2007/08. Table 1: Descriptive Statistics of the Variables

Equity Premium Terrorism (Killings) Law & Order Government Stability External Conflict Internal Conflict

Mean 0.05 1185.50 3.23 7.29 8.39 6.06

Median 0.02 1406 3.25 6.33 8.63 5.75

Minimum -3.86 105 3 5 6.92 5.50

Maximum 5.39 2871 3.50 9.83 9 7.08

Standard Deviation 0.61 985.31 0.24 1.92 0.57 0.56

 

Table 2: Correlation of Equity Premium with its Determinates  Terrorism External Conflict Internal Conflict Law & Order Government Stability Government Regime Change Financial Crisis

Equity Premium -0.11 (-7.02)* 0.18 (12.25)* 0.32 (22.27)* 0.15 (9.69)* 0.05 (3.25)* 0.10 (6.34)* -0.25 (-17.20)*

Note: Values in parentheses are student t-values. * indicates that value is statistically significant at 1% level of significant.

Figure 2 explains the pattern of equity premium of non-financial firms in Pakistan. It is evident from the figure that there are high fluctuations in equity premium of many firms. Figure 3 elaborates the number of deaths in terrorism in Pakistan. After the vent of 9/11, terrorist incidents increased in Pakistan, as a result, number of killings also increased. 10

Killings surged after 2006 when suicide attacks increased in the country. However, terrorism started to decline after 2013 when government initiated security measures in the country. Figure 2: Equity Premium 6

4

2

0

-2

-4 500

1000

1500

2000

2500

3000

3500

4000

 

Figure 3: Number of Killings in Terrorist Incidents (2001 – 2014) 3500 3000 2500 Killings

2000 1500 1000 500 0

Years 4.3. Estimation and Interpretation of Results We will estimate our model (equation 1) using panel data technique. Panel models are estimated using fixed effect model (FEM) or random effect model (REM). Selection between FEM and REM is made by using Hausman (1978) specification test. REM is preferred under the null hypothesis due to higher efficiency, while under the alternative hypothesis FEM is at

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least consistent and thus preferred. On the basis of Hausman test we have estimated our model using fixed effect method. The estimated results are reported in Table 3. Firm equity premium is the dependent variable. The results in column (1) show that the coefficient of terrorism is negative and statistically significant. It implies that when terrorism increases in the country equity premium decreases. The estimated value of the coefficient implies that one percent increase in terrorism will decrease equity premium by 0.112 percent. This result suggests that government needs to take appropriate measures to tackle terrorism issue in Pakistan because increase in terrorism incidents will thwart the performance of stock market, which, in turn, adversely affects firm equity prices and their premium. The coefficient on law & order is positive and statistically significant, which indicates when law & order condition improves in the country equity premium increases. The estimated value of the coefficient indicates that one percent improvement in law & order situation will increase firm equity premium by 1.427 percent. The value of coefficient is high, which indicates the importance of law & order for equity market. Government stability has significant positive effect on equity premium. Although statistically this result is highly significant but economically this result is weak because the estimated value of the coefficient is small in magnitude. The estimated value of the coefficient indicates that one percent increase in government stability will increase equity premium by 0.017 percent. Political conditions remained more or less stable in the country for the last one and half decade and this might be the reason that market absorbs such information and hence this variable has trivial effect on firm equity premium. This result corroborates the findings of Qureshi et al. (2010) and Tabassam et al. (2016). Political system of the country also affects equity premium. The estimated value of the coefficient of government regime change implies that when political system moves from autocratic system to democratic system in the country, equity premium increases by 0.297 points. This result is not only economically significant also statistically significant. This finding indicates that democratic era is contributing positively to the stock market performance. This result is consistent with the findings of Porta et al. (2007) and Jong-a-Pin (2009). This results support the notion that firm prices are also affected by political system, besides economic and financial variables. Financial crisis dummy has significant negative effect on equity premium. The value of the coefficient indicates that after financial crisis firm equity premium has decreased by 0.307 point. This result corroborates the findings of Porta et al. (2007) and Jong-a-Pin (2009).

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In column (1) the value of the coefficient of determination

is 0.18, which implies

that 18 percent variation in the equity premium is due to noneconomic variables. Relatively, low value of coefficient of determination

indicates that in Pakistan equity premium is

mainly influenced by macroeconomic and company fundamentals. However, this 18 percent value of

is good enough to explain that the contribution of noneconomic variables in

determining equity premium is high and important. Column (2) provides the sole impact of terrorism on equity premium. Again the effect is negative and statistically significant. The value of

is 0.051, which implies that 5 percent variation in firm equity premium is

explained by terrorism. When law & order variable is included in the model,

increases

from 5 percent to 11 percent (column, 3). A similar interpretation applies to the remaining columns. In all columns, all variables appear with the theoretically expected signs, and are consistently statistically significant. The values of F-statistics are highly statistically significant, which implies that the models fit the data well. The values of the Durbin-Watson (DW) statistics are close to the desired value of 2, which indicates the absence of autocorrelation problem. Table 3: Estimated Results of Equity Premium Intercept Terrorism Law & Order Government Stability Regime Change Financial Crisis

Adjusted S.E. of regression F-statistic Prob. (F-statistic) DW statistics

(1) 2.645 (6.299)* -0.112 (-4.030)* 1.427 (12.828)* 0.017 (2.740)* 0.297 (4.746)* -0.307 (-14.270)* 0.180 0.116 0.576 2.811 0.000 2.180

(2) 0.116 (3.689)* -0.011 (-2.258)**

(3) 1.246 (17.455)* -0.114 (-14.004)* 0.817 (17.928)*

(4) 3.331 (8.689)* -0.021 (-2.938)* 1.078 (15.693)* 0.118 (6.028)*

(5) 4.463 (11.947)* -0.001 (-2.030)** 1.948 (20.199)* 0.053 (2.620)* 0.623 (11.699)*

0.051 0.022 0.617 1.694 0.000 2.053

0.110 0.041 0.602 1.596 0.000 1.982

0.116 0.047 0.601 1.686 0.000 2.014

0.137 0.069 0.597 2.034 0.000 2.047

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Note: Values in parentheses are student t-values. * (**) indicates that value is statistically significant at 1%(5%) level of significance.

For robustness analysis we have re-estimated our model by replacing terrorism variable first with external conflict and then with internal conflict. The results are reported in Table 4. Column (1) reports the results of external conflict and column (2) reports the results of internal conflict. The estimated coefficient of external conflict is positive and statistically significant. The value of the coefficient implies that one percent increase in external conflict index (i.e. improvement in external conflict) will increase equity premium by 0.123 percent. The coefficient of internal conflict is also positive and statistically significant and the value of the coefficient indicates that one percent increase in internal conflict index (i.e. improvement in internal conflict) increases equity premium by 0.460 percent. All other variables maintain their sign and significance level. However, the magnitudes of the values of the coefficients have changed. For instance, the value of the coefficient of law & order has decreased in Table 4 compared to Table 3 (column, 1). The value of the coefficient of government stability has increased. Similarly, the coefficients of government regime change and financial crisis have also changed. If we look at the magnitude of the coefficients (in absolute terms), internal conflict has greater effect on equity premium (0.460) compared to external conflict (0.123) and terrorism (0.112). It indicates that internal conflict is more important for financial markets. In fact, both terrorism and internal conflict in Pakistan is foreign funded mainly by India because Pakistan has external conflict with India over the issue of Kashmir and India is using Afghan territory to promote terrorism and internal conflict in Pakistan. Internal conflict model has more explanatory power compared to external conflict model and terrorism model as value of coefficient of determination in internal conflict model is 26.8 percent, while in external conflict model it is 15.6 percent and in terrorism model it is 18 percent.

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Table 4: Estimates with External Conflict and Internal Conflict (1) 3.307 (9.6303)* 0.123 (6.254)*

Intercept External Conflict Internal Conflict Law & Order Government Stability Regime Change Financial Crisis

R-squared Adjusted R-squared S.E. of regression F-statistic Prob (F-statistic) DW statistics

(2) -4.487 (-7.937)*

0.657 (3.486)* 0.152 (11.591)* 0.283 (2.573)** -0.368 (-13.666)*

-0.460 (-24.036)* 0.937 (6.314)* 0.211 (19.890)* 1.086 (12.866)* -0.192 (-9.130)*

0.156 0.090 0.578 2.372 0.000 2.290

0.268 0.211 0.554 4.681 0.000 2.322

Note: Values in parentheses are student t-values. * (**) indicates that value is statistically significant at 1%(5%) level of significance.

5. Conclusion The paper quantifies the impact of non-economic factors on firm level equity premium in an emerging market of Pakistan using panel data technique. For this purpose data is collected for 306 non-financial firms listed at Pakistan stock exchange market for the period 2001 to 2014. The non-economic variables included are terrorism, law & order, political stability, government regime change and financial crisis of 2007/08. The estimated results reveal that terrorism has statistically significant negative effect on firm equity premium in Pakistan. The estimated value of the coefficient reveals that 1 percent increase in terrorism activities will decrease equity premium by 0.112 percent. The magnitude of this effect is very small, which indicates that despite significant terrorist incidents across the country in the past one and half decades, the capital markets have absorbed this effect and have not taken terrorist risk seriously. Law & order variable has significant positive effect on equity premium, that is, law & order condition improves equity market. Government stability

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also has significant positive effect on equity premium. The estimated value indicates that 1 percent improvement in political stability will improve equity premium by 0.017 percent. Similarly, government regime change i.e. shift from autocratic system to democratic also significantly positively influence equity premium. When political system shifts from autocracy to democracy equity premium improves by 0.297 points. The result also reveal that global financial crisis of 2007/08 has negatively affected the firm equity premium in Pakistan. The paper has some important policy implications. The results reveal that terrorism risk is an important factor in explaining firm equity premium. Since terrorism adversely affects firm equity premium, investors should diversify their investment portfolio to hedge against terrorism risk. Alternatively, investors should invest in those assets which can react positively to terrorist attacks or have little or no negative sensitivity to this risk. In Pakistan the effect of terrorism on equity market is small, therefore, it is suggested that (long-term) investors should not get panic and should not sell the securities instantaneously. The regularity authorities should take appropriate steps to make the stock market efficient in absorbing the impact of terrorist attacks and to protect the financial markets from terrorist shocks. The companies should provide additional information to asset holders during such cataclysmic events to increase their confidence levels. Law & order has high impact on equity premium, therefore, government should take steps to improve law & order situation in the country. Although government has started a war against terrorism but more needs to be done in this regard. In Pakistan terrorism is mainly foreign funded, government should revise its foreign policy with India and Afghanistan. The results suggest that political stability improves firm equity premium, therefore, it is necessary to increase political stability in the country to improve equity market. Further, democratic system has restored invertors’ confidence. Therefore, democratic government culture should be promoted in the country. The study can be expanded in many ways. For instance, current study examines the effect of non-economic variables on equity premium of non-financial firms. A similar research can be conducted to explore the effect of non-economic variables on equity premium of financial firms. This is left for future research.

Acknowledgments This research is supported by National Natural Science Fund (71572071), China Postdoctoral Science Foundation funded project (2015M571708), Research and Practice Project of Teaching Reform of Graduate Education in Jiangsu Province (JGZZ1_056), Advanced Talent Project of Jiangsu University (09JDG050 & 14JDG202) and Higher Education Commission of Pakistan (085-12336-Be5-152).



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Highlights:     

The paper empirically examines the effect of terrorism on equity premium in Pakistan. Terrorism negatively affects equity premium in Pakistan. Equity premium increases with the improvement in law & order situation in the country. Equity premium also increases with government stability and when there is democratic system in the country. Global financial crisis of 2007/08 has negatively influenced the firm equity premium in Pakistan.