/1/05
Reaction of the euro/dollar exchange rate to the result of the May 2005 French election rejecting the proposed European constitution. Daily trading range of theeuro/dollar exchange rate from April 1, 2005 to July 31, 2005.
FIGURE 4.5
The French vote no.
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1.18004/1/05
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Two points should be kept in mind. First, the referenda resultsaccorded with expectations. Yet, there was a substantial market reaction to what was expected. Second, the effect was relatively long-livedcontrary to what the theory of market efficiency would suggest. Theformer effect can be explained, in part, by the existence of dispersionaround consensus expectations. This meant that even a situationwhere there was no apparent forecast error would surprise some market participants and lead to further appreciation of the dollar againstthe euro. However, the latter effect (i.e., the delayed reaction to thenews of the French referendum results) is not easily reconciled withthe notion of informational market efficiency.It should also be emphasized that traders did not wait until thevote before placing their bets—nor was the foreign exchange marketthe only place to wager on the outcome of the referenda. In anticipation of a majority of French and Dutch citizens voting no, many speculators sold government bonds of EU member countries—whoseeconomies are perceived to be weaker—and bought the bonds of EUmember countries whose economies are considered stronger.32Such spread-widening trades had a fair amount of risk associatedwith them. These risks arise as the result of leverage as much as froma bet on the election outcomes. The probability of a no vote in Francevaried substantially over the month before the vote on Sunday, May29. This volatility in expectations of the election outcome wasreflected in the market price of a contract on the outcome of thereferendum.For instance, on May 2, 2005, Tradesports.com, an online bettingsite offering opportunities to wager on various events, reported a bidprice of 49.3 and an ask price of 51.3 for the contract that Frenchvoters would approve the EU constitutional treaty. (The price of thecontract varied between 0 and 100. A price of 100 corresponded toabsolute certainty that French voters would approve the treaty,whereas a price of 0 corresponded to absolute certainty that Frenchvoters would reject the treaty.) The Tradesports.com Web site also
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showed that the price of a yes vote outcome on the EU constitutionreferendum steadily increased from a contract low of 38.6 on April 28to 50 on May 2. Put differently, the prices of the EU constitutionaltreaty contract on the Tradesports.com Web site suggested that theprobability of French approval of the constitutional treaty wasincreasing.Volatility in consensus expectations creates more opportunitiesfor traders to profit from a correct position as well as increases therisk of any position taken. Increased volatility in consensus expectations also impacts how a rational trader would trade this event.Namely, a trader would take a smaller position in the spread wideningor spread narrowing trade in the eurozone bond market.Traders looking at the prospect of the French or Dutch referendaserving as trading catalysts would have likely looked at the reaction ofthe financial markets to the rejection of the Treaty of Maastricht byDanish voters in the summer of 1992. Even though the subject ofthe two referenda differed, the background situations had somesimilarities.
Terrorist ActionsAlthough terrorist acts against U.S. interests outside the UnitedStates have increased in recent years, terrorist acts on U.S. soil havefortunately been limited. The market impact of terrorist acts on U.S.soil has been mixed. Both the February 26, 1993 World Trade Centerbombing and the April 19, 1995 Oklahoma City bombing had littleapparent effect on U.S. financial markets as measured by the behavior of the Dow Jones Industrial Average. In fact, the DJIA roseslightly on both days. In contrast, the September 11, 2001 terrorist
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attacks on the World Trade Center, the Pentagon, and United Airlines flight 93 had a dramatic negative impact on financial markets.Terrorist acts are more common outside the United States. Thefinancial market impact of such acts has also been mixed. Althoughsuch acts have impacted local or regional markets, there has oftenbeen no appreciable impact on U.S. financial markets. There havebeen a number of significant terrorist actions around the world. Thissection considers only a few terrorist actions and assesses their financial market impact. This is not meant to diminish the tragic loss inhuman lives from the numerous terrorist actions not considered, suchas the March 20, 1995 Sarin poison gas attacks on the Tokyo subwaysystem; the October 12, 2002 bombing of a bar in Bali; the September 1-3, 2004 terrorist seizure of a school in Beslan, Russia; or theseemingly countless terrorist acts in parts of the Middle East.The question naturally arises as to why one should consider terrorist actions as trading catalysts. Surely, only those with foreknowledge of the terrorist acts would be able to profit from trading off ofterrorist acts. Indeed, an unusual surge in the volume of put optionson airline and property insurance company stocks led some observersto openly question whether some traders had advance knowledge ofthe terror attacks on September 11, 2001.33 Subsequent investigation,however, did not support such allegations.Terrorist acts may be as unpredictable as earthquakes. However,the market’s response to such actions may be entirely predictable. Itis in that response that trading opportunities and risks may arise.Trading opportunities and risks may also arise with presumed terrorist actions. For instance, the crash of American Airlines flight number587 to Puerto Rico outside John F. Kennedy international airport at9:17 a.m. shortly after takeoff on November 12, 2001 immediatelyraised fears of another terror attack. This sparked a temporary selloff
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in stock prices with the Dow Jones Industrial Average plummetingalmost 200 points before rebounding to close down 53.63 points. Notsurprisingly, airline and travel industry stocks were especially hard hitby the news.34
September 11, 2001At approximately 8:45 A.M. on Tuesday, September 11, 2001, ahijacked passenger airplane intentionally crashed into the northtower of the World Trade Center complex in New York City. Lessthan 18 minutes later, a second hijacked airplane intentionallycrashed into the south tower of the World Trade Center complex.When the second collision occurred, it was immediately apparentthat the first crash was not an accident but a terrorist attack. Thecrashes not only tore large holes into the buildings but also startedfires. Less than two hours later, both the south and north towers ofthe World Trade Center collapsed. At approximately 9:43 A.M., a thirdhijacked passenger airplane crashed into the Pentagon, igniting a fireand causing part of the building to collapse 27 minutes later. At aboutthe same instant in time, a fourth hijacked airplane crashed in thefields of rural Pennsylvania when passengers—alerted to the terroristattacks in New York and Washington—resisted the hijackers.35 Morethan 3,000 innocent people were killed in the terror attacks.U.S. equity markets had not opened when the terrorist attacksoccurred in New York and did not open until Monday, September 17,so it is not possible to get an immediate read of the U.S. stock market’s assessment of the impact of the terrorist attacks. The electronically traded e-mini S&P 500 stock index futures contract traded onthe Chicago Mercantile Exchange was open. The larger pit-tradedS&P 500 stock index futures market was not open at the time of the
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attacks and did not reopen until Monday, September 17. Eurodollarfutures traded at the Chicago Mercantile Exchange, and Treasurynote and bond futures traded on the Chicago Board of Trade wereopen at the time of the attacks but closed shortly thereafter. Bothmarkets reacted sharply.36 Currency futures markets at the ChicagoMercantile Exchange were also open at the time of the terroristattacks but closed shortly thereafter.The currency market was open at the time of the attacks. Figure4.6 depicts the reaction of the Swiss franc—a traditional safe haven intimes of crisis—to the terrorist actions in the United States. Consistent with the safe haven trading thesis, Figure 4.6 shows that thevalue of the Swiss franc rose against the dollar (i.e., it took fewerSwiss francs to buy a dollar). Many European markets were also openat the time of the terrorist attacks. The following report from AgenceFrance Press notes that European stock prices fell sharply.…Stock prices dived in response to the attacks—the Germanstock market plunging 9.1 percent, Paris falling 5.74 percentand London shedding 3.0 percent. Trading on the New Yorkstock exchange was suspended. The euro meanwhile firmedin response to the crisis while oil prices jumped nearly twodollars in London…37The U.S. stock market reopened on Monday, September 17 andgave its assessment of the financial impact of the terrorist attacks ofSeptember 11. The Dow Jones Industrial Average closed at 8,920.70,down 7.07% for the day, whereas the Nasdaq Composite index closedat 1579.28, or down 6.85% for the day. This break occurred despite a50-basis point cut in the Federal funds rate by the Federal Reserveprior to the stock market’s reopening. Not surprisingly, travel industrystocks were hard hit, whereas defense and security company stocksrose.38
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1.84001.8200
9/11/01date.open 1.6886date.high 1.6919date.low 1.6372date.close 1.6410
1.80001.78009/11/01Terrorist acts
1.76001.74001.72001.70001.68001.66001.64001.62001.60001.5800
8/2/01
9/2/01
10/2/01
11/2/01
Reaction of the Swiss franc/dollar exchange rate to the terrorist acts of September 11, 2001. Daily trading range of the Swiss franc/dollar exchange rate from July 1, 2001to November 30, 2001.
FIGURE 4.6
The Swiss franc acts as a safe haven.
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The financial market’s response to the terrorist attacks had several components. First, there was a flight to safety as stocks fell,bonds and gold rose, and the dollar fell against the euro and the Swissfranc. Second, oil prices rose in the belief that the supply of oil maybe more uncertain. Third, there was a belief that the terrorist actionswould spark a recession, which is often viewed as positive for bondsand negative for stocks. (Note that a recession would probably resultin a decline in oil consumption, which is inconsistent with theobserved rise in oil prices.) Fourth, airlines, hotels, and other travelindustry stocks were hard hit (due to a perceived drop in travel) alongwith property and casualty insurance companies (due to a perceivedincrease in payouts associated with the World Trade Center destruction). Fifth, security and defense stocks rose in the belief that suchcompanies would benefit from increased business following the terrorist attacks. It should be noted that the various components thatcomprised the market’s reaction to the terrorist acts lasted for different lengths of time. The flight to safety response was much shorterlived than the assessment that travel industry stocks would be hard hitin the aftermath of September 11, 2001.
Madrid Train Bombings, March 11, 2004On Thursday morning, March 11, 2004, a series of bombs explodedon trains in Madrid, Spain killing 191 innocent people during themorning rush hour. The bombs were placed on four different trainsand were intended to go off simultaneously when all of the trainswere in the station. Had the bombs exploded simultaneously in thetrain station, thousands of people may have been killed. Fortunately,they did not. Bomb explosions occurred from 7:39 to 7:42 A.M.,Madrid time. The bombs were the work of terrorists affiliated withthe al-Qaeda terrorist group. The terror group demanded the withdrawal of Spanish armed forces from Iraq.
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The timing of the bombings—three days before a Spanish general election—ultimately claimed another victim as Mariano Rajoy(incumbent prime minister and President Jose Maria Aznar’s choiceto succeed him as prime minister) was defeated in his election bid byJose Luis Rodriguez Zapatero. Newly elected Prime Minister Zapatero announced his decision to withdraw Spanish armed forces fromIraq a few days later.Spanish stocks fell 2.2% in response to both the terrorist attacksand lower U.S. stock prices the day before.39 The financial impact ofthe Madrid train bombings was not limited to the Spanish stock market. Rather, a number of foreign markets were also affected, as thefollowing excerpt from a column by Brian Blackstone in Dow JonesNewswires on March 11, 2004 makes clear.…Rush-hour bomb blasts in Madrid train stations…[sent]equity markets plummeting and boost[ed] safe-havendemand for government securities. Demand waned asreports linked the attacks to Basque separatist group ETAand not international terrorists.The yield on the benchmark 10-year Treasury note fell as lowas 3.67% on the news, and remained near 3.70% in early afternoon trade despite encouraging [economic] reports…The10-year German bund…fell two basis points to 3.90%, andJapan’s 10-year note fell four basis points in yield to 1.285%.The dollar…fell slightly versus the euro and more notablyagainst the Swiss franc…The price of gold languished, eventhough it’s also traditionally viewed as a safe harbor…, butanalysts say market fundamental factors are weighing moreon the yellow metal than the events in Madrid.40As the preceding excerpt notes, U.S. Treasury bonds, Germanbonds, and Japanese government bonds were all impacted by the terrorist attack. The terrorist action served as a trading catalyst boostingthe demand for “safe haven” assets. However, the report also notes at
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least one puzzling reaction: namely, gold “languished,” even though itis regarded as a safe haven investment. The apparent rationale forgold’s non-response (i.e., other fundamental factors were pushingdown the price of gold) highlights the importance of understandingthe factors driving each market.By design, the terrorist bombing in Madrid was intended to affectthe election result. The reaction to the vote on Monday, March 15,2004 was even steeper than the initial reaction to the terrorist bombings. Indeed, the change in stock prices on Monday was a combination of a reaction to the election and the terrorist attack. The SpanishIBEX stock index fell in excess of 4%.41Uncertainty associated with the terrorist attack in Madrid and theelection outcome impacted other markets. The U.S. stock marketclosed down 1.34% as measured by the Dow Jones Industrial Averageand down 1.43% as measured by the S&P 500 stock index. Nasdaqclosed down 2.9%. Separating the reaction to the election outcomefrom the reaction to additional information on the probable cause ofthe Madrid train bombing is not possible. However, it is likely thatU.S. stock prices reacted more to the additional information aboutthe Madrid train bombing than the election of Zapatero if the generallack of U.S. stock market reaction to past foreign elections is anyguide. Yet another explanation is that market participants assumedthat the election of Zapatero would be seen as a capitulation to terrorists and, thus, evidence that terrorism is effective. This, in turn, wouldincrease terrorism around the world. In any event, whatever the relative impact on market prices, both events represent geopolitical riskand adversely impacted financial markets.
Terror in London, July 7, 2005At approximately 8:52 A.M. London time on Thursday, July 7, 2005,the first in a series of explosions occurred in the London underground subway system. This was followed some minutes later by an
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explosion on a bus. More than 56 people died from the terror attacks,including some of the suicide bombers. The London terror attackshad an immediate impact on financial markets as reported in USAToday on July 8, 2005.…On a hectic Thursday: Europe’s Dow Jones Stoxx 600Index had the biggest loss since August. The benchmark fell1.8% to 274.69 after losing as much as 4.2%. Travel relatedstocks, including British Airways, led the decline along withinsurers. In New York, both the Dow Jones Industrial Average and the Standard & Poor’s 500 index lost about 1% beforerecovering lost ground. By late afternoon, the Dow was down8.06 points at 12,262.12…The Nasdaq Composite index wasup 0.93 at 2069.58. Treasuries rose, sending the benchmark10-year note’s yield as low as 3.93%, before a later retreatsent the yield back above 4%.42Once again, markets followed a pattern similar to the response toprevious terrorist actions—sharp price declines followed by partialrecoveries. One difference is that the reaction to the London bombings was shorter lived.
Impeachment of South Korean PresidentRoh Moo-hyunOn Thursday morning, March 11, 2004, South Korean President RohMoo-hyun was impeached from office for violating an electoral lawprohibiting government officials from trying to influence the outcome of elections. The South Korean Parliament determined that thepresident had violated the law when he stated on February 25, 2004that he would support the Uri political party “within the limits of thelaw” in the April 15, 2004 parliamentary elections. The president’srefusal to apologize for his comment led opposition political parties todemand and force his impeachment (subject to review by the Korean
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Constitutional Court). The reaction in Korean financial markets,which were open at the time, was swift and sharp. The Korean wonfell against the dollar; the yield on three-year Korean governmentsecurities fell sharply, and the Korean stock market fell as much as5.5% before rallying to close down only 2.5%.43A March 12, 2004 story from Yonhap News Agency indicatedthat market participants expected the financial market impact of theimpeachment to be short-lived.The South Korean parliament’s impeachment of the country’spresident rattled its financial markets Friday. The Koreanwon plunged 11.80 to the dollar to end at 1,180.80, while thenation’s key bond yield fell .04 percentage point to 4.57 percent…Dealers said the unprecedented move caused the wonto tumble against the greenback, but its descent was limitedon rumors the government intervened to prop up the localcurrency. However, they predicted the flap over the impeachment crisis may soon die down…Analysts said the parliamentary vote to impeach President Roh was the main reason forthe tumble in share prices on the main bourse. An overnightfall in U.S. stock prices was also responsible.44The preceding excerpts indicate how political actions can impactfinancial market prices. The apparent trading thesis triggered by theimpeachment was a flight to safety. Korean investors sold stocks andbought Korean bonds and U.S. dollars. The magnitude of the overreaction in the Korean bond and stock markets is interesting. Asnoted earlier, the yield on the three-year South Korean Treasury notewas down, at one point, 10 basis points yet (according to the YonhapNews Agency excerpt) closed down only 3 basis points. Similarly, asnoted, the stock market was down 5.5% at one point during the trading session but closed down only 2.5%. Put differently, there was asubstantial snapback rally after the initial selloff in stocks and a substantial break in the three-year Treasury note price after the initial
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rally. These are violent price moves within the larger price move. Theprincipal lesson for a trader trading on the initial news of theimpeachment is twofold: have a short trading horizon and reduceyour position size.
Coup d’Etat: The Gorbachev OusterIn the early morning hours of Monday, August 19, 1991, forces loyalto hardliners in the Communist Party of the Soviet Union staged acoup d’etat. President Mikhail Gorbachev was put under virtualhouse arrest and special Red Army tank units were sent to Moscow. Asix-month state of emergency was imposed. The resistance of thousands of ordinary Soviet citizens, Moscow Mayor Boris Yeltsin, international pressure, and basic blunders by the coup leaders caused thecoup to collapse and Mikhail Gorbachev was restored to power onAugust 21. The coup exerted tremendous pressure on financial markets and caused a flight to safety.News that Gorbachev had been ousted and placed under housearrest while vacationing in the Crimea created pandemonium infinancial markets. Markets in Asia, Australia, and New Zealand wereopen when the news broke. The basic trading thesis was a flight tosafety. The dollar rose against the various European currencies. Theprice of gold rose and equity prices plummeted. The situation andmarket outlook remained dire when European markets opened a fewhours later. At one point, the Israeli stock market was down over 10%.The impact of the news on equity prices started to diminish as timepassed. By the time the U.S. market opened, there was only a littlemore information. The Dow Jones Industrial Average opened downand fell over 100 points during the early part of the trading day andclosed down almost 70 points in terms of the Dow Jones IndustrialAverage, a far lower response than in many other equity marketsaround the world. Some of the power of the Gorbachev ouster as a
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trading catalyst is captured in the following news report by The WallStreet Journal on Tuesday, August 20, 1991.…Bond prices ended slightly lower after an early surge. TheDow Jones industrials dropped 69.99 points, or 2.4%, to2898.03 in heavy trading. Over-the-counter stocks lost 2.9%.Shares fell more sharply on markets elsewhere, with pricesplunging 5.95% in Tokyo, 9.4% in Frankfurt and 3.1% inLondon.The…damage [to the economy] so far seems psychological.Petroleum prices shot up on fears of a disruption in the flowof Soviet oil. Crude futures rose $1.17 to $22.47 a barrel.Grain prices in the U.S., meanwhile, plummeted amid concern that the U.S. will lose its biggest corn and soybean mealcustomer. Precious metals surged in Tokyo and Europe butretreated in New York as their “safe haven” appeal gave wayto worries that the Soviets may increase sales of gold andplatinum.45The return of Mikhail Gorbachev to power on August 21, 1991acted as a trading catalyst for financial markets as well. Market participants fled their safe haven investments and returned to equities,prompting U.S. stocks to soar over 3% and the dollar to fall.46Did the market’s reaction to the news of Gorbachev’s ouster andreinstatement really make sense? 47 The Soviet Union was a militarysuperpower given its possession of nuclear weapons and the means todeliver them. At the same time, it was an economic basket case. President Mikhail Gorbachev’s attempts to increase personal freedomsthrough a policy of glasnost—political openness—and reform theeconomic system via a policy of perestroika—restructuring—onlysucceeded in bringing lingering resentments against the Soviet Communist Party and government to the surface without providingincreased economic output.The Gorbachev attempted coup teaches an important tradinglesson—namely, that the initial reaction to such an episode that
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foreign stock markets may be more sensitive to geopolitical factorsthan the U.S. stock market. Although there was time for more information to get out, it is not clear that the U.S. market was respondingto the eventual failure of the coup as to other factors. The motivationfor panic selling even if Gorbachev was overthrown is also unclear.There is opportunity in panic situations. Note, though, that the reasoning behind a trading catalyst need not make sense.Although Gorbachev was restored to power, his remaining tenurein office was short-lived. By the end of 1991, the Soviet Union collapsed after 74 years of existence. The Cold War was over.
Trading LessonsThere are numerous factors that drive markets. This chapter illustrates how geopolitical events may serve as trading catalysts for significant price moves in financial markets. One recurrent lesson in thisbook is that traders learn from past market reactions to similar events.The sharp rally in stock prices and fall in crude oil prices prior to theinvasion of Iraq in March 2003 can be attributed, in part, to tradersanticipating a stock market rally and break in crude oil prices whenwar became certain, because that is what happened during the lastGulf War when stock prices surged on January 17, 1991 and crude oilplummeted. Past market reactions also influence traders’ perceptionsof the relationship among prices to certain events and the tradingtheses traders develop—that is, traders may have more than one trading thesis about how a given trading catalyst should affect marketprices. For example, a terrorist act may induce a flight to safety asbond prices are bid up and stocks are sold. It may also adversely affectfirms in the travel industry or the property and casualty insuranceindustry. Some of the effects may be relatively fleeting, whereas othereffects are longer lived. Sometimes, the implications of the various
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trading theses conflict with one another. The duration of tradingcatalyst-induced effects is as important to traders as the magnitude ofsuch effects.Another lesson is that there may be delayed reactions to politicalevents. And the delayed reactions to political events may be larger inmagnitude than the initial reaction. This was seen in the delayedreaction to the Indian parliamentary elections of 2004 when pricesfell almost 17% intraday on May 17, 2004 before closing down 11%.The reaction of Indian stock prices on May 17, 2004 also demonstrates that market prices routinely overreact to geopolitical events.This was also apparent in the bond market reaction to the probableelection of Luiz Inacio Lula da Silva as president of Brazil when thespread widened to over 2400 basis points over comparable maturityTreasury bonds on September 27, 2003. This tendency to overreactmay sometimes be due to factors internal to the market. In any event,the tendency for market prices to overreact to trading catalysts creates potential opportunities for traders. Less apparent but no lessimportant is the tendency of markets to not always move in sync inresponse to news. This is less apparent within an asset class, likestocks, but more apparent across differing asset classes. All in all,geopolitical events create risks and opportunities for traders and givethose individuals who are better able to anticipate or discern theprobable course of political events—and the likely market reaction—an edge in trading.
ReferencesAgence France Press. “Russian Stock Market Plummets After OilTycoon’s Arrest.” October 27, 2003.Agence France Press. “Indian Stocks Plunge on Investor Fears aboutNew Government.” May 17, 2004.
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Associated Press Newswires. “South Korean Stocks Plunge, DollarRallies After Unprecedented Presidential Impeachment.” March 12,2004.Bilefsky, Dan. “Dutch Rejection of Charter Sparks Larger EUFears.” The Wall Street Journal, June 2, 2005, p. A3.Blackstone, Brian. “Global Yield: Spain Bombings Another Blow toEuro Zone.” Dow Jones Newswire, March 11, 2004.Brancaccio, David. Marketplace. Thursday, March 13, 2003.Brown, John Dennis. 101 Years on Wall Street. Englewood Cliffs,New Jersey: Prentice Hall, 1991.Business Standard. “FIIs Making Market Jumpy: Left; AbsolvingThemselves of Any Blame for Monday’s Bloodbath.” May 18, 2004.Business Standard. “Huge Margin Calls Triggered Free Fall; Do NotBlame It All on the Left.” May 18, 2004.CNN.com. “September 11: Chronology of Terror.” Posted 12:27 P.M.EDT, September 12, 2001 (www.cnn.com).Dennis, Neil. “Spectre of French No Casts Pall over Euro.” FinancialTimes, May 28/29, 2005, p. 11.Dizard, John. “Global Investing—The Long and Short of BrazilianBetting.” Financial Times, September 6, 2002.Dizard, John. “Global Investing—Playing Spread Poker withEurope’s Bonds.” Financial Times, May 2, 2005.Dow Jones International News. “Europe, US Investigate SuspiciousPre-Attack Trades-Report.” 10:46 A.M., September 16, 2001.Dow Jones Newswires. “India Sensex Ends Up Provisional 8.6% at4893.64.” May 18, 2004.Duclaux, Denise. “U.S. Stocks Drop, Security Fears Plague WallStreet.” Reuters. 12:51 P.M., March 15, 2004.The Economist. “India’s Stockmarket, Contumacious Fetishism.” May28, 2005, pp. 76-77.
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Heller, Jeffrey. “European Stock Markets Recover from EC Shock.”Reuters, June 4, 1992.Hesse, Baldwin. “Markets Nosedive, Rebound on News of Blasts.”USA Today, July 8, 2005, p. 7A.Karp, Jonathan. “Candidate’s Gains Pummel Brazilian Currency.”The Wall Street Journal, September