The Impact of Terrorist Attacks on Stock Returns and Volatility: Evidence from

Colombo Stock Exchange

Nishalika Mapa
Department of Finance
Faculty of Management & Finance
University of Colombo
Colombo 03
Sri Lanka
(iyeshmanthi@gmail.com)

Prabhath Jayasinghe
Department of Business Economics
Faculty of Management & Finance
University of Colombo
Colombo 03
Sri Lanka
(prabhath@fmf.cmb.ac.lk)

To appear in Sri Lanka Economic Journal, Vol 13, No. 1, 2012

Abstract

This study examines the impact of terrorism on stock returns and volatility
from an econometric perspective. Taking daily returns within the sample
period May 1985 – January 2007, the relevant hypotheses are tested in the
context of the Colombo Stock Exchange. A GARCH specification is used to
estimate parameters, thus explicitly allowing for the time-varying volatility
effect. The attacks are chosen based on the number of civilians killed,
whether the attacks are targeted at significant people or significant locations.
The research results in a few important findings. First, there exists a
significant relationship between the news of terrorist attacks and stock
returns. Second, the relationship between the news of terrorist attacks and the
volatility of stock returns is also significant when all types of attacks are put
together, though the results are not very consistent when each type of attack
is considered separately. Third, the study cites evidence in support of a weak
learning effect over a time span of two decades.

Key Words: Terrorist Attacks, Stock Returns, Stock Market Volatility,

GARCH Models

Electronic copy available at: http://ssrn.com/abstract=2462047

 The Impact of Terrorist Attacks on Stock Returns and Volatility: Evidence from
Colombo Stock Exchange

1 Introduction
“The fluctuations in the share price indices are
indicative of the uncertainties in the security situation.
With every slight expectation of peace, the indices rise.
Similarly, with every indication of terrorist activity like the killing of soldiers, the indices
decline”
- The Sunday Times Economic Analysis, Sri Lanka.

Whether it occurs in one part of the world or the other, terrorism has become a
phenomenon that affects the performance of stock markets all over the world. The impact
of the September 11th attack provides a classic piece of evidence. The impact of a
terrorist attack is usually two fold. Death, injury, and capital destruction are seen as the
direct or visible effects of such incidents. The impact of the news of those attacks on the
way people make their investment decisions can be viewed as an indirect effect. In the
context of various forms of the efficient market hypothesis wherein unanticipated news
play a crucial role in determining the asset prices, this indirect impact is of particular
importance. News of terrorist attacks affects not only the return on a stock, but also the
degree to which returns fluctuate or the volatility of stock returns.

There is a stream of literature which inquires into the relationship between the
news of terrorist attacks and the returns and/or volatility of returns in many developed
stock markets. It would be a sensible exercise to examine such impact on the stock
market in Sri Lanka, history of whose terrorist attacks dates back to even 1980s.
Ironically, there is a dearth of studies that reliably examines the severity of the impact of
terrorist attacks in the context of the Colombo Stock Exchange (CSE). Even the few
existing studies that address this issue seem to have captured the effects with the naked
eye and have interpreted the results with emotions driven by the value judgments of the
researchers. The quotation at the beginning of the section is just one example for many of
those. This paper attempts to fill the gap. More specifically, it has two important

Electronic copy available at: http://ssrn.com/abstract=2462047

objectives. First, an attempt is made to econometrically evaluate the impact of a set of
selected terrorist attacks on stock returns and the volatility of stock returns. Second, it
examines whether the CSE has undergone a learning effect so that the severity of the
impact of the news of terrorist attacks fades away over time.

The findings of the study will help to improve investor awareness of the behavior
of stock returns in the face of terrorist attacks, enabling them to make more accurate
decisions. Findings can also be used to draw effective policies and regulations in order to
ensure that the CSE performs in a more stable manner in the face of terror attacks.

The rest of the paper is organized as follows, Section 2 briefly reviews the
relevant literature. The selection procedure of the sample of attacks to be taken into
account is described in section 3. The econometric model proposed to evaluate the impact
of terrorist attacks in the context of CSE is outlined in Section 4. Section 5 describes the
nature of the data and. Empirical findings are reported in detail in Section 6. Section 7
offers concluding remarks.

2 Review of Literature

This literature review is for three main purposes. First, it focuses on some definitions of
terrorism. Second, it discusses various kinds of researches that have been conducted on
the topic of terrorism, giving special attention to the relationship between terrorism and
financial markets. Finally, it reviews the various methodologies adopted by previous
researchers in similar studies.

Defining Terrorism

Before the second half of the last century, terrorism took the form of being country
specific. However, during the 1970’s ‘Terrorism’ became an international concept which
involved activities like napping of significant people, attacks on foreign countries,
hijacking of planes etc. Yet, however popular the word ‘terrorism’ became, no single or
common definition to the word can be found in the literatures. Enders and Sandler (2002)
define terrorism as “[t]he premeditated use or threat of use of extra-normal violence or

3
brutality by sub national groups to obtain political, religious, or ideological objective
through intimidation of a huge audience, usually not directly involved with the policy
making that the terrorists seek to influence” (as cited in Llussá & Tavares, 2007, p. 62).
As a result, many definitions to the word terrorism can be found in literature where the
researchers have defined the word according to situations that prevailed. However, as
Crenshaw (1992) shows “most definitions of terrorism, however divided on other points,
agree that it is a form of political violence”.

Previous work on terrorism and financial markets

The impact of terrorism and its widespread effect on financial markets have been looked
at from various angles (Chen & Siems, 2004; Blomberg, et al., 2004; Eldor & Melnick,
2004; Jhonstan & Nedelscu, 2006). Eldor and Melnick (2004) analyses how terrorism
affects the stock market prices of different sectors of an economy. In their study, all
sectors of the economy are identified to be affected. The adverse macroeconomic effect,
the nature of the market to absorb information as and when it happens can be taken to
assume that stock markets must react in positive ways when they hear of counterterrorism
measures and act in negative ways to counterproductive ones (Zussman and Zussman,
2006).

Drakos (2004) identifies that both idiosyncratic and systematic risk with regard to
the September 11 attack to have increased in a set of airline of stocks. According to
Schneider and Tröger (2004), the defense sector is found to benefit occasionally from war
while other sectors such as aviation, hotels, leisure tend to loose profits due to improved
hostilities.

In research related to terrorism, a problem most researches face is getting the

correct number of incidents along with the number of casual deaths, injuries etc. Most of
the time, the source of information on terrorist attacks is official reports. However, it is
not always reliable to gather information from these sources because either the authorities
are not informed or they deliberately bias their reporting to suit their needs (Frey, 2007).

4
 Eldor and Melnick (2004) have classified terror attacks by geographic location
(whether the attack took place in a major city or elsewhere), target type (public
transportation, facilities, personnel, military, government and other) attack type (suicide,
cold weapon, armed assault, bombing, kidnapping and other), total number of people
injured and killed, number of attacks per day and hour of the attack. According to the
tests run with this classification, the location of a terror attack had no effect on the stock
markets performance. Their findings also conclude that the most statistically significant
type of attacks were the number of incidents per day, the number of casualties of an
attack and whether it was a suicidal bombing.

Research has also been done focusing on one specific terrorist event/attack. This
is mostly conducted when the impact is felt in great extents or when the impact becomes
universal. Many studies analyze the impact of the 9/11 attack (Jhonstan & Nedelescu
2006; Chen & Siems 2004, inter alia). Another event that has been carefully analyzed in
this manner is the Basque ETA declared between 1998-1999 (Abadie and Gardeazabal,
2003).

In analyzing one off events like 9/11, the time span of evaluation is very short.
However, when the attacks occur on a more frequent basis, the analysis should include a
longer time period to identify the impact they bring about. It is through studies like these
the learning effect of terrorism can be observed. It can be argued that, with attacks that
are prevailing for a long time period or those that occur in a more frequent manner, the
impact felt by the investors may decline as time goes on. However, this notion is
debatable as the nature of attacks tends to differ and one can only state with accuracy of
such a learning effect if all attacks are of the same nature. Eldor and Melnick (2004)
argue that one cannot speak of diminishing impact of terrorism over time as the
information content for each and every attack tends to differ. In their research, they have
obtained the results tested to be statistically not significant from zero, thus drawing the
conclusion that there is no diminishing effect present over time. On the contrary, Chen
and Siems (2004), a study that evaluates 14 terror attacks that dates back to 1915, show
that the US capital markets have become more resilient to terror attacks over the years,
thus suggesting the presence of a learning effect.

5
Various methodologies to analyze the relationship

Research on terrorism has been analyzed using different methodologies. One of the most
basic methodology types adopted is the descriptive style. Focusing on descriptive
method, Jhonstan and Nedelescu, (2006) goes to present data on the reaction of financial
markets to terrorist attacks in New York and Madrid that occurred in 2001 and 2004,
respectively. The paper describes the authorities’ crisis management responses and
analyses their effectiveness against the attacks that followed. Staub (2002) also draws his
work using the descriptive style on the influences that give rise to terrorism and speaks
about the possible prevention techniques that can follow.

The case study method, a certain type of descriptive analysis, is mostly used to
capture intricate complexities, idiosyncrasies with regard to one particular case. Leivesley
(2006) adopts the case study method to show anticipatory risk as a key determinant of the
frame work of international law with regard to terrorism.

Moving away from the descriptive style, another common method that has been
adopted with regard to research relating to terrorism is the event studies. Chen and Siems
(2004) that examines the effects of 9/11 attack on global capital markets uses this
method. Carter and Simkins (2002) also employ the event study method to evaluate the
effects of the 9/11 attack on the aviation industry. Both studies test for the presence of
abnormal returns surrounding the chosen terror attacks. Drakos (2004) adopts the market
model as the methodology and investigates the effects of terror attacks of September 11
on a set of airline stocks listed in various international stock markets. He contends that
his study is complementary to previous studies as he extends the hypotheses tested.

When the occurrence of the terror attacks are frequent, it is not appropriate to
adopt the event study approach. In such cases, researchers have employed time series
analysis for more comprehensive evaluation. Eldor and Melnick (2007), using the time
series approach, states that terrorism is an act which has macro economic consequences.
The research uses daily data covering 473 terrorist attacks occurring within a period of 4
years (2000-2003). Based on quarterly data and an ARIMA model, Enders et al. (1992)

6
quantify the present value of the loss in tourism revenues for a sample of European
countries.

Following the time series perspective on research, Schneider and Troger (2004)
apply a generalized autoregressive conditional heteroskedasticity (GARCH) specification
to test for the impact of war and other international events or conflicts on stock markets.
A GARCH (1, 1) model is employed to test for significance and volatility with the use of
a dummy variable. What is significant about this research is that they have both tested for
acts of terrorism and counterterrorism with regard to three war situations (Iraq, Israel-
Palestine, Ex-Yugoslavia).

Although the GARCH method has been employed in many researches, its use to
test for the significance on terrorism and its impacts, are few. Also to the best of our
knowledge, there has been no published work of this sort in Sri Lanka. However, there
are few unpublished works carried out at undergraduate or basic levels. Hence, the
present research work has the potential to set a platform for further research in this area –
terrorism and its impacts on financial markets.

3 Selection Procedure of Terrorist Attacks

During the period of 25 years of the existing civil war, the terrorist attacks that were
carried out by the LTTE resulted in a number of civilian deaths, injuries, capital
destruction etc. These attacks vary in their nature and the degree of severity. Some of the
attacks were targeted only at civilians whereas some were targeted at Presidents and other
leading characters of the country. Some of them were even targeted at significant places
of the country and some of them were a mixture of all these. As can be expected, various
attacks caused different damage levels. It is also evident that, as compared to an attack
that takes place in the city of Colombo, an attack that takes place in Jaffna will carry less
significance for many reasons. The evidence suggests that it is sensible to develop a
proper selection criteria to choose the attacks that are believed to be “important” in terms
of the nature of it, the location, and the degree of severity.

7
 Accordingly, three types of attacks have been identified as instrumental in
influencing the stock market performance: (a) the attacks that caused civilian deaths; (b)
the attacks targeted at Presidents, Military Commanders or other significant people
including leading politicians; and (c) the attacks on important and significant places in
the country.

To select the sample related to the “civilians killed”, all such attacks are arranged
in descending order of the number of deaths. The inclusion of all the attacks of this nature
that took place from 1983 in a regression would dilute the total effect, leading to
insignificant dummy variable coefficients in the proposed model. Therefore, the mean
value of the deaths occurred (approximately 21) is taken as the margin to eliminate the
attacks that were thought to have made little impact on the CSE. Accordingly, all the
attacks which resulted in a death toll of more than 21 were selected for this sample.
Selection of the attacks that fall into other two samples is not relatively difficult as the
number of significant individuals assassinated and the number of significant places
subject to attacks already involves a kind of filtering/selection.

Care was taken to avoid the risk of duplication of categorizing one attack in more
than one group. For instance, the attacks that caused assassinations or attempted
assassinations of Presidents, Military Commanders etc as well as civilian deaths were not
considered under the ‘civilian’ category. Based on these criteria’s, out of the total, 220
odd attacks that took place during the period 1985 – 2007, 54 attacks were chosen for the
purpose of this research.

4 Econometric Methodology

The stylized facts associated with financial time series includes time-varying variance
(volatility), volatility clustering, and thick tails of residual distribution (leptokurtosis). It
is argued that a model specification that does not capture these stylized facts is less likely
to result in reliable estimates. To address this issue, a GARCH specification is employed
for the purpose in hand. More specifically, we use the following univariate GARCH (1,1)
model:

8
rt  a  b1rt 1  b2 D  b3 Drt 1   t (1)

 t I t 1 ~ N 0, ht 
1
 t  zt ht 2

h t  c   e t2 1   h t  1   D (2)

where rt is the return on ASPI in time period t; D  1 up to n days after the day on which

attacks occur and zero otherwise;  t I t 1 denotes the random shocks at time t given all

available information at time (t-1);  t is assumed to be asymptotically normally

distributed with mean 0 and conditional variance ht . zt is standardized error with 0 mean

and variance 1. Usual non-negativity constraints such as   0 and   0 apply. For

the variance to be stationary, (    )  1 .

The mean equation is a simple AR(1) structure augmented with two dummy
variables. Here our main focus would be to see whether there is an impact of terrorism
related activities on the stock returns and not to predict stock returns, hence the non-
inclusion of the return on market portfolio or any other macro economic variables as
regressors. Also, unnecessary additions to the mean equations may result in complexities
such as convergence problems.

When the news of a terrorist attack enters the market, for a certain period, the
market tends to react in a different way from its normal. In theory, this is usually referred
to as a period where abnormal returns and/or abnormal volatility can be observed. The
proposed model is able to capture this abnormal behaviour of the market during the days
right after an attack. Statistically significant b2 in Equation 1 implies that the returns
during the n days after the attack are abnormal. A negative sign would imply a significant
reduction in returns. Statistically significant b3 in Equation 1 implies that, during the n
days after the attack, sensitivity of today’s returns to yesterday’s returns is significantly
different from its usual sensitivity to the previous day’s returns. A negative sign would
suggest a reduction of this sensitivity.

9
 Variance equation is also augmented with a dummy variable to check whether the
volatility of stock returns is remarkably different during the attack periods. More
specifically, statistically significant and positive  in Equation 2 suggests that the degree
to which the returns fluctuate during the n days after an attack is significantly higher than
the normal degree of fluctuations of returns. This implies increased volatility or
uncertainty during those n days after an attack.

To estimate parameters various versions of this model has been used. Assuming
that the residuals of the suggested univariate model are normally distributed, the
conditional log-likelihood of residual  t at time t can be defined as follows:

1 2 
 t   ln2  
1
ln ht    (3)
2 2  ht 

where  is the vector of parameters to be estimated. The log-likelihood function of the

sample is obtained as L   t 1  t where T is the total number of observations. The
T

parameter vector of the model is estimated by maximizing L with respect to  using

BHHH algorithm.

5 Data

All Share Price Index (ASPI), which represents the overall market, is assumed to be a
proper proxy to examine the impact of terrorist attacks on the performance of CSE.
Return horizon is taken as a day for the research for two reasons: First, the impact of
terrorist attacks is better captured through daily data as it is more sensitive. Second,
GARCH effects are known to be more pronounced in daily data (Joseph and Vezos,
2006). The period from 1/2/1985 to 2/1/2007 is taken as the sample period which results
in 5251 observations. Daily returns are computed using the formula rt = ( pt  pt 1 ) / pt 1

where rt is the return on ASPI at time t.

10
 Table 1: Descriptive Statistics of ASPI and Return on ASPI
ASPI Returns
Mean 716.4875 0.0007
Median 601.35 0.0002
Maximum 2789.78 0.2006
Minimum 96.05 -0.1297
Std. Dev. 562.085 0.0114
Skewness 1.526 1.6351
Kurtosis 5.122 44.2837
ADF* 1.103 -30.36
Jarque- Bera 3024.114 375228.4
ARCH** - 108.12
* Augmented Dicky-Fuller statistics for the presence of unit roots
** ARCH LM statistics for the presence of conditional heteroskedasticity
Sample period: 01/02/1985 – 01/02/2007

Table 1 reports the descriptive statistics of the price index and the returns. ADF
statistics show that, though the price index is not stationary, return series is stationary and
can be used in regressions. Highly significant ARCH LM statistic implies the presence of
conditional heteroskedasticity. The presence of non-linear dependence and high kurtosis
of the return series justify the use of GARCH specification in estimating parameters.

6 Empirical Findings

In this section, three hypotheses are tested using the estimation results obtained from the
various versions of the proposed model. Regressions are run using the samples which
contain the attacks that caused only civilian deaths, the attacks targeted at Presidents and
other significant people in the country, the attacks targeted at significant places of the
country and, finally, all these types of attacks together. Henceforth, for convenience,
these four samples will be called “Civilians”, “Significant people”, “Significant places”
and “All attacks”, respectively.

Regressions are initially run using the dummies for 20 days after an attack. Since
this exercise resulted in insignificant estimates, we decreased the number of days for
which dummies are used gradually. Eventually, significant results are obtained only with
the dummies used for 1 and 2 days. For this reason, all estimates reported here are based
on dummies used for 1 and 2 days.

11
The Impact of Terrorist Attacks on Stock Returns

To see whether there is an impact of a terrorist attack on returns, the mean

equation of the proposed model (Equation 1) is simply augmented with a simple
GARCH(1,1) structure without dummy variables in it. The validity of the hypothesis is
first tested using the All attacks sample. Then, to check the robustness of the results, the
hypothesis is also tested using the other three samples Civilians, Significant people and
Significant places.

Table 2 reports the estimated parameters of Equation 1 obtained from both OLS
and GARCH specifications using the dummies for one day after the attack and two days
after the attack. More importantly, the OLS specification, which does not incorporate the
stylized facts of the financial time series, is not able to capture the significance of the
impact of terrorist attacks on stock returns. However, the GARCH specification cites
evidence for the presence of abnormal returns right after an attack.

Table 2: Impact of terrorist attacks on stock returns (All Attacks)

a b1 b2 b3
1 Day
OLS 0.0004* 0.3286* -0.0011 -0.0084
(3.22) (25.114) (-0.717) (-0.531)
GARCH 0.00013 0.436* 0.0009 0.1301
(1.607) (34.92) (1.992)* (1.035)
2 Days
OLS 0.0004* 0.3281* -0.0011 -0.0166
(3.278) (25.008) (-0.9974) (-0.1397)
GARCH 0.00015 0.435* -0.0030 -0.08461
(1.843) (34.75) (-10.157)* (-0.750)
Sample period: 01/04/1985 – 01/02/2007; t values are in parenthesis; *
denotes significance at least at 5% level

When dummies are used for 1 day, b2 is barely significant with a t value of
1.99, thus suggesting the presence of abnormal returns on the following day of a certain
attack. Given that b2 is positive, the intercept is expected to take a higher value right

12
after an attack. The slope dummy b 3 is not significant, suggesting that the sensitivity of
today’s returns to yesterday’s returns to be unchanged even after an attack.

When dummies are used for 2 days, b2 is highly statistically significant.

However, the sign of b2 is neagative, suggesting a decrease in returns during the two
days right after an attack than the average returns during the rest of the sample period.
Though this is seemingly contradictory with the 1 day results, it can be reconciled. With
an attack taking place the immediate effect and the news makes it become significant but
the performance level remains the same until investors fully realise the impact.
Thereafter, it leads to a reduction in the returns.

In order to see the robustness of the results obtained from the All attacks sample,
the same regressions are run for the three sub samples: Civilians, Significant people and
Significant places. Results are reported in Table 3. As in the case of All attacks, the OLS
specification is not successful in capturing the impact of terrorist attacks on stock returns
for all cases except for Significant places for 1 day.

Both b2 and b3 are statistically significant in Civilians sample for 1 day analysis,
thus suggesting that the returns and the sensitivity of returns to previous day’s returns are
both increased by the arrival of the news of an attack. However, when it comes to 2 days
analysis, only the sensitivity is significantly affected by the news of an attack. A possible
interpretation will be that the effect of an attack targeted at civilians may die out very
quickly. The impact is so short-lived that it becomes insignificant by the second day after
the attack.

The two samples Civilians and Significant people show mostly similar results.
When the dummies are used for just 1 day, we find evidence for the existence of
abnormal returns and the change in the sensitivity of today’s returns to yesterday’s
returns due to an attack. However, when the dummies are used for 2 days, there is no

13
strong evidence to raise the same argument, thus proving once again that the impact of
terrorist attacks on the returns in CSE is short-lived.

Table 3: Impact of terrorist attacks on stock returns (Civilians, Significant

people and Significant places)
a b1 b2 b3
Civilians – 1 Day
OLS 0.004* 0.328* 0.0004 -0.0593
(3.143) (25.11) (0.226) (-0.315)
GARCH 0.0001 0.4366* 0.0035* 0.4127*
(1.419) (35.022) (5.390) (2.543)
Civilians – 2 Days
OLS 0.00048 0.3270* -0.00084 0.1282
(3.227) (24.981) (-0.6597) (0.8740)
GARCH 0.0001 0.4336* 0.0003 0.464*
(1.673) (34.72) (0.340) (4.748)
Significant People – 1 Day
OLS 0.0004 0.3280* -0.007 0.3401
(3.224) (25.10) (-1.629) (0.951)
GARCH 0.0001 0.4357* -0.0068* 0.6006*
(1.740) (35.217) (-3.668) (2.001)
Significant People – 2 Days
OLS 0.0004* 0.3283* -0.0018 -0.0414
(3.207) (25.128) (-0.6691) (-0.1916)
GARCH 0.00014 0.4370* -0.0025 0.0348
(1.763) (35.318) (-1.768) (0.1339)
Significant Places – 1 day
OLS 0.0004* 0.3282* -0.0102 -1.3548
(3.221) (25.173) (-1.979)* (-1.404)
GARCH 0.0001 0.4385* -0.0099 -1.5171
(1.944) (35.51) (-2.714)* (-1.474)
Significant Places – 2 days
OLS 0.0004* 0.328* -0.0069 -0.7123
(3.214) (25.16) (-1.635) (-1.386)
GARCH 0.0001 0.439* -0.0069 -0.895
(1.897) (35.62) (-3.102)* (-2.36)*
Sample period: 01/04/1985 – 01/02/2007; t values are in parenthesis;
* denotes significance at least at 5% level

The Significant places sample show a somewhat different pattern. When the
dummies are used for 1 day, there exists evidence for abnormal returns, but not for a

14
change in sensitivity of returns to the previous day’ returns. However, when the dummy
is used for two days, there is evidence for decreased sensitivity of returns as well. A
possible interpretation here would be that, when it comes to these type of attacks
(targeted at significant places, more specifically) there is a time lag in absorbing the news
of an attack and it showing up as a change in the sensitivity of returns to the previous
day’s returns.

Overall, there exists evidence for significant impact of terrorist attacks on stock
returns. The news of terrorist attacks is able to change both the magnitude of returns and
the sensitivity of returns to the previous day’s returns. However, the fact that statistically
significant results are produced only by the regressions based on dummies for just 1 or 2
days reveal that this impact is short-lived and dies out relatively quickly. As a general
note, it is important to record here that OLS specification consistently fails in capturing
the impact of terrorist attacks on the stock returns, thus supporting the view that GARCH
specifications outperform OLS specifications in this type of tasks.

The Impact of Terrorist Attacks on Volatility of Stock Returns

To see whether there is an impact of a terrorist attack on the volatility of stock

returns, the variance equation of the proposed model (Equation 2) is coupled with a
simple AR(1) mean structure without dummy variables in it. The validity of the
hypothesis is first tested using the All attacks sample. Then, to check the robustness of
the results, the hypothesis is also tested using the other three samples Civilians,
Significant people and Significant places.
Table 4: impact of terrorist attacks on volatility of stock returns (All
attacks)

c   
All attacks – 1 Day
0.000011* 0.45401* 0.51419* 0.000041*
(44.742) (54.494) (68.190) (10.95)
All attacks – 2 Days
0.000011* 0.45995* 0.50915* 0.000023*
(45.025) (54.277) (66.885) (13.274)

t values are in parenthesis; * denotes significance at least at 5%

level

15
 Table 5: impact of terrorist attacks on volatility of stock returns
(Civilians, Significant places, Significant people)

c   
Civilians – 1 Day
0.0000113* 0.451005* 0.516763* 0.000038*
(44.381) (54.393) (68.303) (10.305)
Civilians – 2 Days
0.0000114* 0.457459* 0.511443* 0.000025*
(44.761) (54.252) (67.125) (13.267)
Significant People – 1 Day
0.0000123* 0.470122* 0.494011* 0.0000462
(45.827) (53.077) (62.264) (1.864)
Significant People – 2 Days
0.0000123* 0.469495* 0.494728* 0.0000170
(45.757) (53.067) (62.385) (1.575)
Significant Places – 1 Day
0.0000122* 0.468042* 0.497531* 0.0000374
(45.632) (53.209) (63.231) (1.452)
Significant Places – 2 Days
0.0000913* 0.151955* 0.555412* -0.00013*
(33.435) (14.239) (48.829) (-18.529)

t values are in parenthesis; * denotes significance at least at 5% level

Results reported in Table 4 reveal that, in the case of All attacks sample, the
volatility dummy is highly significant for both 1 day and 2 days regressions. This
provides evidence to reject the hypothesis that terrorist attacks do not have any impact on
the volatility of returns within the given sample period. Also, the positive sign implies
that right after an attack the volatility increases in the CSE.

In order to see the robustness of the results obtained from the All attacks sample,
the same regressions are run for the three sub samples: Civilians, Significant people and
Significant places. Results are reported in Table 5.

Civilians sample supports the results obtained from the All attacks sample. Within
the sample period, right after an attack, volatility of returns significantly increases. This
result is consistent in both 1 day and 2 day samples. However, the Significant people

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sample, wherein the volatility dummy is not statistically significant, does not support this
view.
Significant places sample shows somewhat peculiar results. First, volatility
dummy is not significant when the dummy is used for just 1 day. Nevertheless, when the
dummy is used for 2 days, it becomes significant. Second, when the dummy is used for 2
days, it is significant with a negative sign, thus proposing a reduction in the volatility in
CSE right after an attack. To a certain extent, this finding is counterfactual.

Overall, when all attacks are considered together, there are evidence to argue that
terrorist attacks would lead to increased uncertainty represented by high volatility.
However, when attacks are taken separately based on their nature, we get mixed results.
This result is consistent with some previous findings. For instance, Schneider and Troger
(2004), that examine the war impacts on volatility of stocks, also produce mixed results.
Peculiar results obtained from the Significant places sample may be due to the influence
of the “other factors” which are assumed to remain constant in the analyses of this sort ,
though they may not remain constant in reality.

The presence of a Learning Effect

We also test for the presence of a possible learning effect in CSE. In simple terms, the
study search for the evidence for the fact that the investors became immune to the
terrorist attacks over a time span of twenty years. The proposed model is used for
regressions without the dummy in the variance equation (Equation 2). For this purpose,
sample period is readjusted excluding the ceisefire period as it would result in an
insignificant dummy coeffcient anyway. Accordingly, the new sample peiod is
04/01/1985 – 29/11/2001 which is divided into four sub-sample periods: (a) 04/01/1985 –
29/12/1989; (b) 02/01/1990 – 31/01/1994; (c) 01/02/1994 – 31/12/1998; (d) 04/01/1999 –
29/11/2001.

If CES experienced a learning effect over time, then the statistical significance of the
dummy coefficient b2 in Equation 1 becomes insignificant over time. First, the
regression is run for the entire sample period. Estimated parameters of Equation 1 are

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reported in Table 6. As can be expected, there is evidence for the presence of abnormal
returns right after an attack.

Table 6: Impact of terrorist attacks on returns (entire sample

period: 04/01/1985 – 29/11/2001)

a b1 b2 b3

-0.00001 0.47416* -0.00250* 0.001761

(-0.104) (28.443) (-7.750) (0.0182)

t values in parenthesis; * denotes significance at least at 5% level

Then in order to test for the presence of a learning effect, the same model
specification is used for four sub-sample periods. Estimation results are reported in Table
7.
First and three sub-sample periods yields statistically significant dummy
coefficients whereas second and fourth sub-sample periods results in insignificant
dummy coefficients. At first glance, this cites evidence against a learning effect.

Table 7 Impact of terrorist attacks on returns (four sub-sample periods)

a b1 b2 b3
04/01/85 - 29/12/89
-0.000132 0.34831* 0.006381 0.409572
(-0.744) (7.626) (15.101)** (2.877)**
02/01/90 - 31/01/94
0.000367 0.61530* -0.000765 -0.16021
(1.848) (21.142) (-0.673) (-0.695)
01/02/94 31/12/98
-0.0000913 0.52010* -0.00446* -0.42054*
(-0.577) (20.344) (-5.596) (-2.563)
04/01/99 - 29/11/01.
-0.000235 0.26645* 0.000455 -0.22204
(-1.052) (6.474) (0.0938) (-0.461)

t values in parenthesis; * denotes significance at least at 5% level

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 First and three sub-sample periods yields statistically significant dummy coefficients
whereas second and fourth sub-sample periods results in insignificant dummy
coefficients. At first glance, this cites evidence against a learning effect.

When testing for a learning effect, an implicit assumption on which the analysis is
based is that all attacks are of the same in nature. If attacks are not the same in nature,
investors are likely to take the different types of attacks as a new experience. A close
scrutiny at the type of attacks occurred within the third sub-sample period reveals that
four out of twelve of them are somewhat different in nature. These attacks are: Central
Banks bomb blast; Kolonnawa oil refinery explosion; Colombo World Trade Centre
attack; and the Temple of tooth attack. Therefore, model parameters were re-estimated
for third sub-sample period excluding these four attacks. Results are reported in Table 8.
Interestingly, the dummy coefficients b2 and b3 become insignificant. This proves the
fact that the attacks removed has made a bigger contribution to make the relevant
coefficient significant.

Overall, rejection of the hypothesis that attacks do not have an impact on returns
in the first sub-sample period and acceptance of the same hypothesis in the next three
sub-sample periods imply a weak learning effect in the context of the CSE.

Table 8: Impact of terrorist attacks on returns

(reconsidering the third sub-sample period)

a b1 b2 b3

-0.000178 0.510394 -0.002255 0.21122

(-1.223) (20.379) (-1.305) (0.645)
t values in parenthesis; * denotes significance at least at 5% level

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7 Conclusion

This research has two main objectives: (a) to examine the impact of a set of selected
terrorist attacks on the stock returns and volatility of the stock returns in the context of
the CSE; and (b) to check whether a learning effect came into being in the CSE over
time.

With regard to the first objective, our results lead us to reject the null hypothesis
that ‘attacks do not have an impact on stock returns’ as there is evidence to support a
strong relationship between the news of a terrorist attack and stock returns. A distinction
can be seen depending on the nature or type of an attack where the market reacts
differently to hear, absorb and recover from the shock. Hence, according to our
categorization of attacks, when the attack is targeted at a significant place or location of
the country resulting in capital destruction as well, the market responded more and is
slow to recover from the shock. However, with the attacks that carried only civilian
deaths and injuries and those which were targeted at Presidents or key social figures of
the country the recovery rate is much quicker. Throughout the analysis, OLS
specifications are outperformed by GARCH specifications in capturing the impact of
terrorist attacks on stock returns.

As for the impact of terrorist attacks on the volatility of stock returns, the research
results in satisfactory findings. When all attacks are taken together, there exists evidence
for a significant relationship between the news of terrorist attacks and the volatility of
stock returns. However, these results are not very consistent when the tests are performed
for each type of attack separately. For instance, attacks targeted at Presidents and key
social figures of the country are less likely to have significant impact on the volatility of
stock returns. However, the attacks that were targeted at critical places and locations of
the country seemed to have had significant impact on the volatility of stock returns.

Estimated results initially do not support the notion that there is a learning effect
in the context of CSE. Within the first and the third sub-sample periods, regression results
clearly provide evidence for significant impact of terrorist attacks on stock returns.
However, when the third sub-sample period is reconsidered excluding four major attacks,

20
nature of which are somewhat different from the other attacks, there is no evidence that
attacks exert a significant impact on returns. Accordingly, when there is evidence of
significant impact of attacks on returns within the period January 1985 – December 1989
and the absence of such evidence thereafter until the end of 2001 implies the presence of
a weak leaning effect in the context of CSE.

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